Sunday, December 30, 2012

How to evaluate a life annuity

I have often been asked if a life annuity is a good investment. The answer is - depends on what you get for the sum that you have to put in.

This example shows how you can evaluate the life annuity, including a deferred annuity where you have to save now for several years and draw the annuity payout from a certain age.

You have to make an assumption on your life expectancy. It will be suitable to take age 85 for males and 88 for females. This allows for improvement in life expectancy in the future.

The next question that you have to consider if the expected yield, if you invest on your own, instead of a life annuity. It is appropriate to take an interest rate of 5% for long term investment in an indexed fund, such as the STI ETF.

To get a better idea, you can use 3%, 4% and 5% in your projection. See the example in this paper.

It showed that the deferred annuity gives a yield slightly below 4%. This is an acceptable yield, but the drawback is the penalty that have to be suffered, if the investor needs to terminate the annuity earlier. To offset this penalty, the yield has to be better than 4%.

You can use the same approach to evaluate any other type of life annuity, including the more common type, where you have to pay a single premium to buy the annuity.

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