Peace of mind, at a cost: 10 things to know about annuities

This article is the first in a series of articles on annuities, to be published by SuperGuide over the next few months.

The Global Financial Crisis, and the financial carnage that followed, devastated the value of many Australian retirement portfolios. For some retirees and prospective retirees, the risk of another sharemarket crash has redirected attention to the possibility of a guaranteed income in retirement, taking the form of an annuity.

In the past, annuities were expensive and rigid, and very few companies offered this type of product. At one stage, only one company in Australia offered lifetime annuities. The lack of interest in annuities was cemented with the abolition of the Age Pension assets-test exemption for certain lifetime income streams (including annuities) in 2004, and then in 2007. The rising investment markets from 2003 to 2007 were also a contributing factor in the death of the traditional lifetime annuity: many investors compared the double-digit returns on the sharemarket available at the time against the 4% return (approximate) on annuities, and decided to take their chances on the investment markets.

Some investors are reconsidering their options and wondering whether peace of mind is worth more than the potential for higher returns, despite the extra costs associated with accepting a guaranteed income stream.

As a starting point for those exploring a guaranteed income stream as an option, I have set out at least 10 things you should be aware of when considering annuities.

1. What is an annuity? An annuity is a financial product that guarantees a fixed annual income, usually in the form of a series of payments throughout the year, in return for a lump sum payment. The term ‘annuity’ is usually associated with lifetime annuities, although an annuity can also be a guaranteed income stream for a fixed term, such as 20 years or 15 years, and even 10 or 5 years. Note that any income stream paid by a life insurance company is called an ‘annuity’, such as an account-based annuity (similar to an account-based pension) but the industry usually uses the term ‘annuity’ to mean a guaranteed income stream, typically a lifetime annuity.
2. Age Pension is like an annuity. The taxpayer-funded Age Pension operates like a lifetime annuity. Each fortnight you receive a guaranteed income payment, which is indexed in line with inflation or the cost of living. You receive this income whether the investment markets are booming or collapsing, and whether you’re sick or well, subject to meeting the eligibility tests, including the income and assets test. If you’re receiving a part Age Pension, or a full Age Pension, then you already have a form of lifetime annuity as part of your retirement portfolio.
3. What type of company offers annuities? Annuities can only be provided by life insurance companies, and such companies are regulated by the Australian Prudential Regulation Authority. The companies offering such products don’t generally call themselves ‘life insurance companies’ but they hold a life insurance licence. Typically, the annuities are marketed by a broader financial organisation holding the life insurance licence. Examples of some of the companies offering annuities include AXA, BT Challenger and CommInsure. Note that listing these companies in this article is not a recommendation of the companies or an endorsement of the products offered by these companies.
4. How do annuities work? In exchange for a lump sum amount, typically a payout from a super fund account, a financial organisation promises (guarantees) to pay you a fixed amount for your lifetime, or for a fixed term. You can arrange that you have no money left at the end of the fixed term, or a certain amount that is repaid to you at the end of the term. If you buy a lifetime annuity, you may have the option to negotiate a minimum fixed term of payments, in case you die early, which would then be paid to your spouse or dependants. You can purchase an indexed annuity to ensure that your income is indexed with inflation.
5. How does the guarantee work? The guarantee is that the company supplying the annuity will pay you the promised income. The guarantee is not an absolute guarantee of payment. The guarantee is provided by the financial organisation providing the annuity, and although rare, the annuity is still subject to the risk of the company collapsing. The guarantee is different to the current guarantee that the Government has given to bank deposits. Note that life insurance companies are highly regulated and monitored and it is not in the interests of the Federal Government of Australian economy for such a company to fail, although the risk of company failure still exists.
6. How much do they cost? Good question. It can be difficult to unpack the cost of an annuity because the annual income you receive is based on a formula taking into account investment costs, investment risk, profit for the operator and administration and marketing costs. The annuity providers can promise a certain return on your lump sum, which is usually after deduction of costs so you will not see costs deducted from the payment. For example, one provider explains the product as carrying no ongoing management fees and that the earnings rate quoted at the start of the annuity will be the return for the life of the annuity. The provider invests in a mix of assets to generate sufficient returns to pay you an income, cover costs and pocket some profits as well. If the provider makes more than the promised earning rate on your lump sum, then good luck to the provider. If the provider makes less than what they promised to pay you, then bad luck to the provider because you still get paid and they will have to make up the difference.
7. Why should I opt for an annuity rather than an account-based pension? I cannot answer this question for you. If peace of mind is paramount, then an annuity may be the way to go, but it can come at a greater financial cost than an account-based pension, and it generally means you can no longer access your lump sum. The lack of access to your capital is often the major deterrent to taking out an annuity. The providers of annuities are now trying to offer more flexible products to entice retirees, but you will have to make your own decision whether they are right for you. Many of the providers are suggesting retirees put some of their money into an annuity, while retaining the rest of your money in non-annuity savings, so that you can maintain flexibility over your savings. For some Australians, removal of income uncertainty is worth more than higher returns on more flexible account-based pensions. In recent years, account-based pensions with significant money invested in the sharemarket and listed property market have struggled to recover from the GFC and the economic fallout from the world’s love affair with packaged debt instruments (such as CDOs and other synthetic instruments).
8. What are some of the disadvantages of an annuity? I have referred to some of the disadvantages already but briefly, for the same asset allocation, you can expect a lower return than what you could receive in an account-based pension due to the cost of payment risk that the annuity provider must cover. What this means in practical terms is that the money from annuities is often predominantly invested in fixed interest products with a percentage in growth assets to supply the annuity provider with the profit necessary to make it worthwhile from a business perspective, while typically, account-based pensions generally have a higher percentage of money invested in growth assets such as shares and property. In return for the guaranteed return/income of an annuity, you have less transparency over what happens to your money because, in effect, it is no longer your money – unless you have an annuity that provides a lump sum at the end (residual capital value), or you have signed up for a fixed term annuity with a return of capital or part-return of capital.
9. If I die young, will my family get any money? This is the stumbling block for many Australians. If you purchase a lifetime annuity and you die young, then your money goes to the annuity provider, unless you have a minimum payment term as part of the annuity contract. If you have a minimum payment term, then your spouse or dependants can continue to receive payments for the rest of the term, or they may be paid a lump sum. You can also purchase a reversionary annuity which means your spouse gets income payments if you die, but you can expect to pay a lot more for this type of product. Note that annuities can sometimes be advantageous when being assessed for aged care fees (see an adviser familiar with the aged care rules for more information), which means you and your family will need to weigh up the comforts and peace of mind of today, with the benefits passed onto the family tomorrow.
10. Can my super fund offer an annuity? No, but you may be a member of a super fund that pays lifetime income streams — about 10% of the working population belong to such super funds. Long-term public servants and teachers are usually the lucky recipients of this retirement option. Many defined benefit funds, including some public sector funds, may automatically pay super benefits on retirement in the form of a lifetime indexed income stream. An indexed pension is an income stream that increases in line with inflation or increases in average weekly earnings. Many lifetime pensions from the older super funds also pay the member’s spouse a pension after the member dies (a reversionary pension). The downside of belonging to such a fund is that you don’t have any choice about what you do with your super in retirement, and if you and your spouse die not long after you retire, your children may not receive any money from your super fund.