Guaranteed income pensions provide certainty against market crashes and outliving savings but involve tradeoffs.
Annuities are a relatively small part of Australia's retirement-income market but inflows leapt last year as some retirees sought a safe haven from investment markets.
However, the question being asked is whether it's wise to lock yourself into a long-term annuity when interest rates are so low.
According to researcher DEXX&R, the amount of money going into annuities jumped 66 per cent to $2.8 billion in the year to September 30.
The previous year's inflows had slumped 31 per cent, following a 52 per cent jump in the 12 months after the Lehman Brothers collapse.
Annuities involve exchanging a lump sum for a guaranteed monthly payment for a set number of years or for life. Unlike account-based pensions, their returns are not tied to movements in investment markets but locked in at the outset. Proponents say they guard against two key risks for retirees: the risk that a market crash will destroy their funds - again - and the risk that they'll outlive their money.
Others argue that there are better, or cheaper, ways of generating or protecting retirement income, particularly when annuities are currently being sold with earnings rates of as little as 5 per cent to 6 per cent.
THE PROS AND CONS
An adviser at GEM Capital Financial Advice, Mark Draper, says he has concerns about inferior interest rates, the lack of flexibility from locking your money up, transparency regarding the assets underlying the products and the counterparty risk of relying on a provider being around in 30 years' time.
Russel Chesler, the executive director of Sunstone Partners, a boutique consulting firm specialising in wealth and asset management, says a lifetime annuity is the only way to insure against outliving your savings. "This is known as longevity risk and is a real issue as people live longer and longer," he says.
However, there are tradeoffs for getting payments for the whole of your life, even if you live a long time, he says.
For one, you forgo the opportunity to achieve better returns by investing this money elsewhere. Also, many people don't like the idea they might not be able to leave any leftover funds to their family (depending on the product).
Australia's leading provider, Challenger, says a 65-year-old woman who put $350,000 into an annuity with a 22-year term - out to her median life expectancy of 87 - would currently qualify for an earning rate of 5.71 per cent and receive an annual payment of $28,300.
In this example, a total of $672,618 in principal and earnings would be paid out and, though there would be no residual value to be handed back - or bequeathed - at the end of the term, should she pass away before reaching 87 the balance of her capital would be commuted and paid to her estate. The annual payout would be lower if the retiree wanted a residual value at maturity.
That's the median life expectancy, though, so statistically speaking a 65-year-old woman has a 50 per cent chance of living longer than 87. If the retiree bought a lifetime annuity instead, her $350,000 would translate into an annual payment of $24,317 for as long as she lived. (In this case, the payout is based on individual factors such as life expectancy, rather than being associated with a particular earnings rate.)
With Challenger's Liquid Lifetime annuity product, the balance of her capital would be paid to her estate should she pass away within the first 15 years of the policy but after that, there would be no residual value.
Or she could elect for the policy to be commutable - she'd receive an annual payment of $22,036.93 in exchange for the ability to access all her capital within the first 15 years. Under such a policy, a 65-year-old woman would receive 100 per cent of her capital back at year 15 if she decided to withdraw it.
There's also an option, at extra cost, to index for inflation and people can mix-and-match annuities - for example, to have a higher income in earlier years.
These figures compare with the latest ASFA Retirement Standard of $40,407 a year for a single person to achieve a "comfortable" retirement and $21,930 for a "modest" lifestyle.
A senior partner in the retirement, risk and finance group of consultants Mercer, David Knox, says that, rightly or wrongly, investors and retirees are reluctant to lock their money away for many years in an "immediate" annuity (as opposed to a "deferred" annuity - see box, above).
"In themselves, they're not a poor product," Knox says of annuities, "but [many] people compare them to, say, a term deposit rate that they can get today."
However, some people place a value on the long-term certainty that annuities offer, he says, noting that no matter how good a term deposit rate might be, you can't lock it in for 20-plus years.
The head of financial planning at Chan & Naylor, David Hasib, says that at the height of the global financial crisis, people with annuities continued to receive their regular payments, earning 5 per cent to 7 per cent regardless of what the markets were doing.
Knox, an actuary, acknowledges the criticism that annuities can be more expensive than other alternatives but says this is because of the "long-term promise" the life office is making to you.
And on low earnings rates, Hasib says you might well have been able to lock in an annuity at 14 per cent in the 1980s but only because inflation was eroding your purchasing power. "Five per cent is certainly not exciting but remember, an annuity is not a silver bullet - it's there as part of your asset allocation to give you some stability," he says.
ONE TOOL IN THE KIT
The chairman, retirement incomes, of Challenger, Jeremy Cooper, rejects some of the comparisons made, saying it's not a hare-and-tortoise race with equities or term deposits.
"Annuities are one tool in a tool kit ... it's about locking up a solid, bedrock income," he says. "Challenger is just saying, 'Think about a private pension to top up your [government] age pension before taking risk with growth assets'."
But won't you miss out on future rate rises by locking in now? "It depends whether you want to be forever chasing upside," Cooper says. "What advisers typically tell clients is that if that's their concern, then don't put all your money into an annuity in one hit." You might put a quarter into a five-year annuity now, then if rates go up put in another slice at a higher rate and so on.
As for counterparty risk, Cooper says life offices are highly regulated. Insurers are required to hold assets sufficient to cover their liabilities and policy-holders have priority access to those "statutory" funds in the event of a failure.
Defer for the future
Mercer's David Knox would like to see Australia clear the way for greater use of deferred annuities.
"The deferred annuity concept is a little more akin to what most people understand by insurance," Knox says.
You buy a deferred annuity at 65, say, but payments kick in only once you reach a specified age, probably in your mid-80s.
Knox says the deferral means the annuity isn't as costly upfront, you get to keep managing your other money while you're still active, healthy and interested, but if you reach 85, you have insured against living past your life expectancy or outliving your other funds.
Unfortunately, deferred annuities don't come with the same tax and Centrelink benefits other retirement products do, Knox says.
Benefits of annuities
- You are paid a guaranteed income regardless of how markets perform.
- You don't have to pay tax on your income from age 60.
- If you're aged 55 to 59, the taxable portion of your annuity will be taxed at your marginal tax rate. However, some or all of the tax payable will receive a 15 per cent offset.
- You don't pay tax on investment earnings.
- You have the peace of mind of a regular fixed income.
Drawbacks of annuities
- You can't take out your money as a lump sum.
- You can't see how your money is invested by the fund manager.
- You may not be able to transfer to an account-based pension.
- Annuities may pay less long-term than a market-linked investment.