What are annuities, and how can they help in retirement?

Policy support for lifetime income streams

Annuities have been a niche product in Australia, with less than 2% of super in retirement phase being invested in them due to their complexity, lack of consumer awareness and limited availability within mainstream super funds.

But that’s changing.

In recent years, interest has been boosted by the government’s new requirement for super funds to consider the needs and preferences of members who are retired or approaching retirement to ensure they have greater choice in how they withdraw their super benefits in retirement.

Since July 2022, trustees of Australian Prudential Regulation Authority (APRA)-regulated super funds must have a Retirement Income Covenant to help members achieve and balance three retirement objectives:

• Maximise their expected retirement income
• Manage the expected risks to the sustainability and stability of this retirement income
• Have flexible access to expected funds during retirement.

Progress has been slow, but some funds now offer lifetime income products and more are in development.

How do annuities work?

Annuities are divided into two main types:

1. Lifetime annuity

You receive a regular payment for your entire life, regardless of how long you live. Most lifetime annuities also offer a guaranteed death benefit if you don’t live as long as expected, so the balance of your annuity is paid to your beneficiaries, within certain limits.

While traditional lifetime annuities have fixed payments that never change, these days some offer more flexibility. For example:

• Some can be indexed for inflation
• Some payments can be linked to market movements, offering exposure to growth with some protection against market falls
• Some payments can be linked to changes in the Reserve Bank of Australia (RBA) cash rate, both up and down
• Some allow partial withdrawals.

2. Fixed-term annuity

Fixed-term annuities provide regular payments for a specified term and, for that reason, are sometimes compared to term deposits.

Depending on the issuer, they can be purchased for terms of two or more years, but are usually available for 10 to 25 years and are guaranteed to continue paying you for the term you select.

You can generally choose the frequency of your payments and whether to have all your capital returned as part of your regular income or as a lump sum at maturity. A minimum investment may also apply.

Some life companies also offer a deferred annuity. These products allow you to buy the annuity product but not start to receive payments until after an agreed deferral period.

Annuities and tax

You can buy an annuity with either your super savings or non-super money (such as the proceeds from an inheritance or property sale).

Most annuities have taxable and tax-free components. However, if you use your super to buy an annuity, you receive the same tax concessions as you do within the super system. This means once you reach age 60 and satisfy a condition of release, such as permanently retiring, your income payments are tax free and not assessable for tax purposes.

If you use super money to purchase an annuity, it must be purchased in the name of the person whose super account provided the funds.

What happens to my annuity if I die?

When you take out an annuity, generally you have a choice about what happens to your payments on your death. You can select:

1. Reversionary beneficiary

Your nominated beneficiary receives your income payments until their death, although this is usually at a reduced level (such as 60%).

If the annuity was purchased with super money, the reversionary beneficiary must be a dependent person under super law.

2. Guaranteed period

Your nominated beneficiary receives your payments (either as a lump sum or an income stream) for a set period you select when you buy the annuity.

Unlike a reversionary beneficiary, the income payments received under a guaranteed period are not reduced and are only paid for the guaranteed period.

If you are in a relationship, you are free to purchase your annuity either in your own name or jointly with your partner.

Buying your annuity in a joint name with your partner means you can split the income, which may have tax benefits.

With a joint annuity, when one partner dies, the survivor becomes the owner of the annuity and has access to the money either as an income stream or a lump sum.

Income from your annuity

The income you receive from an annuity is set at the time of purchase. Your payments can generally be received monthly, quarterly, every six months or annually, depending on your personal needs.

You can choose to protect your income payments against inflation by paying an additional fee to have the payments indexed each year, either by a fixed percentage or in line with inflation.

Your actual income payment depends on factors such as how much money you are prepared to pay up front and the interest rate the annuity provider is currently offering.

The payment amount is based on complex actuarial calculations covering things like your predicted lifespan, the options you have selected and the outlook for investment market returns.

The rates offered by annuity providers vary over time, so it’s important to check how the current rates compare with other investment options for your money.

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

An account-based pension provides you with a regular income stream from your super savings in retirement. To invest in an account-based pension, you must have turned 60 and/or met a condition of release for your super.

You choose the asset mix that aligns with your risk tolerance, from conservative (with a higher allocation to bonds and defensive assets) to high-growth (with a higher allocation to shares, property and other growth assets). As returns are linked to market movements, there is potential for earnings growth but also the risk that your savings may run out before you die if investment returns are lower than expected or you live longer than you anticipated.

Annuities, on the other hand, are generally not affected by the performance of investment markets. You are guaranteed to receive set regular payments throughout the life of your annuity.

Account-based pensions also offer the flexibility to vary your payments at any time (provided they meet the required annual minimum pension withdrawal rate set by the government) and to make lump sum withdrawals. Annuities don’t offer this flexibility, which is why many retirees select account-based pensions for their retirement savings.

Annuities and the Age Pension

The means-testing rules to determine your eligibility for the Age Pension include both an income test and an assets test. 

The account balance of an annuity is considered an asset for the Age Pension assets test, while payments from the annuity are assessed under the Age Pension income test. However, lifetime annuities are treated more favourably than term annuities.

Only 60% of the purchase price of a lifetime income product counts towards the assets test. After age 84 (or a minimum of five years), only 30% of the purchase price counts. And only 60% of the income paid from lifetime income products counts towards the income test.

This means lifetime income products can help means-tested pensioners achieve more Age Pension and, when used in conjunction with an account-based pension, a higher level of income overall throughout their retirement.

Benefits and drawbacks of annuities

Benefits

• Guaranteed income regardless of moves in investment markets, providing peace of mind for risk-averse retirees
• Income for the rest of your life (if you choose a lifetime option), regardless of how long you live
• Returns are based on average life expectancies, so if you live longer than the average person, you’ll receive more in total payments
• Once you turn 60 and meet a condition of release, such as retiring, annuities purchased using super money are tax free
• Annuities can be used to supplement other retirement income streams (such as account-based pensions)
• Income payments can be indexed to inflation to protect you from the rising cost of living
• Predictable cash flow from an annuity can be used to cover essential expenses, giving you confidence to spend more from other sources of income and improve your lifestyle
• If you nominate a reversionary beneficiary, they will continue to receive income after you die; if you choose a fixed-term guarantee, your beneficiaries will get some income for a fixed term after you die
• Life annuities can increase your Age Pension entitlement

Drawbacks

• You may be able to achieve higher returns outside an annuity (especially if you buy a conventional annuity at a time of low interest rates), although this may involve more risk
• No control over how the money is invested, which could be an issue for some investors
• It may not be possible to withdraw your money as a lump sum
• You can’t change the terms of payment once the cooling-off period is over
• With a long-term annuity that is not indexed to inflation, your purchasing power is reduced over time
• You may lose a percentage of your money if you cancel the annuity or withdraw your money before the end of its term
• Less flexible than an account-based pension

The bottom line

Annuities can be a valuable addition to your retirement income plan.

When used in conjunction with an account-based pension and possibly the Age Pension, they can increase your overall income throughout retirement and help minimise the risk of outliving your savings.

Although they have many benefits, annuities are complex products with a variety of terms and conditions. So it’s important to seek professional advice about their suitability for your personal circumstances.