What are annuities, and will they work for me?

Recent statistics show that purchasing an annuity is currently the least preferred of the three super drawdown options for Australian retirees, behind lump sum and account-based pension arrangements.

According to the Centre of Excellence in Population Ageing Research (CEPAR), annuities account for just 7% of total pension member accounts and only 4% of total pension members’ benefits. The average annuity is also small at about $17,000.

CEPAR also reported the long term and lifetime annuity market has become dominated by a single provider, Challenger, and that there is a lack of competition in the market as a result.

Share of long term and life annuity sales by provider, 1998-2018

Source: CEPAR, Strategic Insights, 2018

CEPAR concluded: “The Australian retirement risk-pooling market is also one that is lacking in competition. Challenger have over 70% of total annuity market share (Challenger 2018) and have a monopoly of long term and lifetime annuities. The market is changing but is yet to provide a full menu of competitively priced products to help retirees manage risk (e.g., deferred annuities, hybrid annuities, group self annuitisation, etc.).”

However, legislative changes from July 2019 will potentially make annuities more attractive. We’ll explain those changes later in this article.

So how does an annuity work?

In simple terms, an annuity is a ‘guaranteed payment’ at retirement consisting of a guaranteed dollar amount paid to you for a guaranteed specified period or for life. You can buy an annuity from either a super fund or life insurance company using money from an existing super account or personal savings (such as proceeds from the sale of property).

You can usually arrange to have the annuity pay out every month, quarter, six months or annually. To protect against inflation, you can also arrange, usually for an extra fee, to have the annuity indexed each year, either by a fixed percentage or in line with inflation.

The balance of an annuity, and part of the income, is also assessed by Centrelink and may affect what you receive as an Age Pension entitlement.

What are the different types of annuities?

The two main types of annuities are lifetime annuities and specified period annuities, or term annuities, and these usually have flexible options including inflation-linked indexing.

In simple terms, a lifetime annuity guarantees an income payment until you die and eliminates the worry that you may run out of funds. It is possible to have payments transferred to your partner or dependent if you die, if you nominate a ‘reversionary beneficiary’. However, bear in mind that the income stream may be reduced when you pass on.

With a specified period annuity, if you die within the agreed period, your beneficiary will receive the remaining income payments as an income stream or lump sum. Unlike the reversionary beneficiary option, the income payments received under a guaranteed period will not reduce and are only paid for the guaranteed period.

Specified terms typically range from 10 to 25 years, depending on the product.

There’s also the option of a deferred annuity which allows you to invest in your preferred annuity product, then receive payments later after the initial sum has accrued interest, usually after at least several years. You can usually contribute in one lump sum or make several contributions over a longer period of time.

How does an annuity differ from an account-based pension?

An account-based (or allocated) pension provides you with a regular income stream in retirement using your super funds. This type of pension is available to you once you’ve reached preservation age or met a condition of release.

The main difference between an account-based pension versus an annuity is the length of time that you receive payments.

How long your account-based pension payments will last will depend upon:

• The funds you allocate to your account-based pension.
• The investment returns of your pension account.
• The fees you are charged by your super fund.
• How much you elect to receive in pension payments each year.

There is a minimum amount that you must withdraw each year, which is determined by your age. You also have the option of withdrawing the balance as a lump sum (thus ending the pension).

The Productivity Commission, in its final report to the government on the superannuation sector released in January 2019, released results of its survey which revealed annuities, in general, scored lower in satisfaction levels from investors than account-based pensions and SMSFs.

Subjective assessments about retirement products

Source: Productivity Commission report on Superannuation, 2018, Members survey

The Centre of Excellence in Population Ageing Research (CEPAR), in its report titled “Retirement Income In Australia”, went so far as to describe annuities as “poor value for money” as part of its summary.

“While the availability of annuity products has grown, the demand for them has been lacklustre. One reason may be that current products are poor value for money” the CEPAR report states.

How much should I allocate to an annuity?

CEPAR’s researchers developed a stochastic lifecycle model to investigate this question in Australia and the modelling involved a choice between risky assets and either a fairly priced immediate or deferred annuity (purchased at 65, to pay out at 85). It was based on single male home owners reaching retirement with different levels of accumulation.

CEPAR concluded: “The researchers find that in the absence of an Age Pension, 38% of one’s wealth should be used to buy an annuity, and higher if the market is more volatile. The rate is lower when the Age Pension is included – about 18% for someone with an accumulation of $500,000. Interestingly, the findings also show that annuitizing all savings is worse than annuitizing nothing, especially when the retirement asset is low.”

What is the optimal way to annuitise?

Pros, cons and potential risks of annuities

The pros

• Guaranteed retirement income regardless of market movements (and financial crises).
• Income for the rest of your life (if you choose this option), regardless of how long you live.
• Lifetime annuity returns are based on average life expectancies. If you live for longer than the average person, you’ll receive more in total payments.
• From the age of 60 onwards, annuities purchased using super are tax-free.
• Annuities can be used to supplement other retirement income streams (such as account-based pensions).
• Payments can be indexed to increase each year to combat the effects of inflation.
• Investment earnings are tax-free.

The cons

• Your annuity is a fixed-return investment and may provide lower returns than other higher risk super investments.
• You have no control over how your annuity is invested.
• Once you’re locked in, you may not be able to transfer your money out of the annuity contract.
• Residual annuity funds may not be payable to your dependents/next-of-kin after your death.

The risks

• If you take out a long-term annuity, your purchasing power is reduced over time due to the effects of inflation.
• You might lose a percentage of your lump sum investment if you opt to cancel the annuity or withdraw your money before the end of the annuity’s term.

Annuities and the Age Pension – recent legislative changes

Eligibility for the Australian Government Age Pension is determined by both income and assets tests and based on age criteria. If you exceed these limits you’ll either get a reduced Age Pension, or no Age Pension at all.

As we mentioned earlier, an annuity account balance is considered an asset for the Age Pension assets test. Annuity payments are also included in the Age Pension income test. There is a change scheduled for July 2019 that only 60% of an annuity’s purchase price will be included in the assets test (reducing to 30% for people aged over 84), instead of the full purchase price.

These changes could improve your eligibility for the Age Pension even if you have annuities.

What is the best way to use annuities?

Annuities could be considered as one part of your retirement income strategy, rather than being your entire strategy. Diversifying your retirement income streams could help you to maximise your returns while minimising your risk. However, the ideal amount is dependent on a retiree’s financial circumstances and goals.

The information contained in this article is general in nature. You should seek independent professional advice to determine if annuity products are appropriate for your situation.