Thursday, August 09, 2007

Pooling of Risk under a Life Annuity

A life annuity allows all the participants to pool their risk and guarantee the an attractive payment for the lifetime of the annuitant.

Someone argued in my blog against buying a life annuity. He advocates keeping the money in the CPF and drawing it out over 40 years. He does not expect any annuitant to live beyond age 100.

A minimum sum of $99,600 at age 55 will accumulate to slightly more than $130,000 at age 62, assuming interest at 4% per annum.

If you draw down this sum of $130,000 over 20 years (and you continue to earn 4% per annum), you can receive $813 a month. If you participate in a life annuity, you will be able to get this sum payable for a lifetime, as the average lifespan is 20 years. Those who die younger leave behind the balance of their capital in the pool to continue the payment to those who live behind 20 years.

If you wish to keep the money in your personal account, and you want to draw down the sum of $130,000 over 40 years, you can receive only $558 a month. This is a reduction of 32% (compared to $813). There is no pooling of risk. On death, there is a balance in the account that can go into the estate.

Which is better? $813 a month (with pooling of risk) or $559 a month (with no pooling of risk)?

Note: At present, no life insurance company is able to guarantee a payout of 4% per annum, as the return on government bonds is less than 3%. If the Central Provident Fund provides the life annuity and pays the guaranteed 4% per annum, they will be able to pay out $813 over a lifetime.

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