Annuities have suffered a lot over time – bitcoin-based annuities, while not likely anytime soon, could reinvigorate the industry.
What is an annuity and why are they important?
An annuity is usually a fixed sum of money paid to a person each year, often defined as payable for the rest of their life. These were usually purchased from retired insurance companies. A typical annuity quote would be something like, in exchange for every £15 (~US$20.34) of initial cost, I will pay you £1 (~US$1.36) of income each year. These are an important part of the retirement landscape. This is particularly true for individual pensions or defined contribution pensions, which now make up the majority of pension schemes in the UK, where individuals have their own separate ‘pot’ or pension allowance.
Therefore, the cost of an annuity can be conceptualized as the cost of retirement, since it forms the link between the pool of money saved and the guaranteed income that can be realized from it.
Why have annuities gotten a bad rap?
This “cost of retirement” has increased considerably in recent years. As the examples in this link illustrate, the income paid out in exchange for a £100,000 fund (~$135,522) for a 65 year old rose from just over £7,000 (~$9,486 USD) in December 2006 to approximately £5,100 (~US$6,911) in December 2021. This example is for a simple life pension (no dependent pension is paid) with no guarantee period or other complexities.
In other words, if you want a fixed income to be paid to you at retirement in the form of an annuity, you now need to save about 25% more than someone who retired at the same age 15 years ago.
Additionally, £5,100 (~$6,911) is the pension payable which does not increase over time. If we want our pension to increase by 3% per year, our £100,000 (~135,522 USD) will currently only pay us an annual starting amount of £3,400 (~4,607 USD). If we live to be 20, this annual amount will have increased to £6,141 (~US$8,322), which explains the much lower starting pension.
There are two main reasons for the much higher annuity prices over the past 15 years. First, government bond yields have fallen dramatically. The annualized yield on UK 15-year gilts (government bonds) declined from around 4.7% to 1.15% over this period. Annuity providers are priced based on this, as they invest the initial cost of the annuity in UK gilts to get a risk-free return on your fund before they have to pay you the income each year. A lower return on gilts means a lower return on the underlying investments and therefore a lower annuity conversion rate.
Second, life expectancy has also increased over the past 15 years. While this should be generally welcomed as good news, it will naturally be reflected in the pricing of annuities by insurers. That said, the driver of higher annuity rates, as noted above, has largely been driven by the first factor – huge interest rate changes.
This is relatively easy to validate on your own in an annuity calculator, like this one here. Leave the withdrawal amount blank (to solve for) and enter interval = “annual”, starting capital = “100,000”, annual growth rate = “1.15%” and annuity term = “22 years”, then compare the result to the same inputs but with an interest rate of “4.7%”.
Given the worsening of these annuity rates, the UK media has been somewhat scathing in terms of offering value annuities. This coincided (and perhaps helped) with the relatively recent advent of ‘freedom pensions’ rules in the UK. when they retire at their convenience.
These freedoms generally proved popular, and annuity purchases declined significantly. However, in taking a lot of money, there is considerable risk of taking too soon (the common refrain in the media was that retirees would splurge on Lamborghinis immediately upon retirement), or, as is closer to reality, to take too little . There is also the risk that, if not invested appropriately, a bear market at the wrong time could seriously affect your retirement capital. Studies have shown that if this happens early in retirement, in addition to having to withdraw regular income to live on, the fund level may never fully recover, even despite a subsequent recovery.
The irony remains that the concept of an annuity is still quite solid, because no one knows how long they will live! Securing a fixed level of retirement income by purchasing an annuity brings great peace of mind. However, there is an innate public feeling that this is bad value, and given that it currently looks like a 1.15% annual return when inflation is much higher, it is difficult to disagree.
What would a Bitcoin annuity look like?
So how could bitcoin get in? Consider that one day, insurers offer bitcoin annuities. These would pay a regular lifetime bitcoin income in exchange for a lump sum of bitcoin upfront. How would this market be different?
My first assumption is that bitcoin does not offer a risk-free rate and therefore the insurer would set the annuity rate at 0% interest rate. Based on current prices and adjusting the interest rate to zero, I would estimate that he would pay 4,545,000 sats per year from a fund of one bitcoin. This is a higher conversion rate than the annuity of £3,400 (~$5,870) increasing by 3% each year (4,545 vs. 3,400, for 100,000 units) which is eventually priced at a negative real interest rate. For a bitcoin-denominated annuity, we would not need an annuity increasing over time, as we expect the value to hold a fixed proportion of the overall supply.
At this point, there are obvious questions and criticisms. First, if the insurer makes no profit from the bitcoin we pass to them to buy the annuity, and just gradually returns it to us, what’s the point? The answer, of course, is to pool longevity experience among a large group of individuals. An annuity provides you with a guaranteed income for life and, in this sense, it remains an attractive product. Indeed, the original concept of an annuity is centuries old.
Other Bitcoiners may also counter that it’s never worth spending your bitcoin. The concept is more future-proof because if bitcoin ever reached the point of a sound and reliable currency that individuals save and spend equally, and is no longer considered a emerging store of value. And even on a future bitcoin standard, the ebb and flow of life remains, nearly everyone must save in their younger years to help fund retirement costs in later years. You also bear the credit risk of the insurer, but this has always been the case when purchasing an annuity.
In this point however, here is the actual elephant in the room. Individuals are unlikely to require a bitcoin annuity product to meet basic retirement income needs when the purchasing power of bitcoin is so volatile in fiat terms.
To conclude, in the much longer term, a less volatile bitcoin price in the future could breathe new life into the concept of annuity, both priced in bitcoin and paid in bitcoin. For now, annuities are likely to remain unpopular because they offer little value with government bond yields so low. One day, bitcoin-based annuities could restore the obvious value proposition that comes from pooling the life expectancies of a large group of individuals to provide everyone with a stable income in retirement.
This is a guest post from BitcoinActuary. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc. or Bitcoin Magazine.
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