|Summary: Longevity is one of the biggest financial challenges for retirees. The longer we live, the longer we have to fund our living costs. Annuities are one way of tacking this issue in providing an income stream for life, but it’s important to know what’s available and how they work.|
|Key take-out: Among the things that need to be considered are comparable fixed interest returns, the opening capital amount required to achieve a certain return, and the willingness to lose ownership of some or all of your capital.|
|Key beneficiaries: General investors. Category: Fixed interest.|
What is an annuity? And is there a place for these ‘income stream’ products in the portfolio of a self-directed investor?
The Financial System Inquiry (FSI) interim report by David Murray released earlier this week (Tuesday July 15) highlighted concerns about the underdeveloped retirement phase of superannuation, which does not meet the risk-management needs with respect to managing investment, inflation and longevity risk, while drawing down retirement savings.
Although no specific recommendations were made, Murray commented that "few retirees use income stream products": In other words annuity-type products.
Annuity-style products have a mixed history in Australia and with the rise of SMSF strategies the market has been sidelined until relatively recently. After the GFC the core attraction of a product that will produce an income regardless of the tempo of investment market has been warmly welcomed by conservative investors.
Despite strong growth in recent times – mostly associated with the rise of the Challenger group as an annuity provider – only 2% of total retirement money is in annuities. This is mostly in fixed term annuities, which have competed alongside term deposits since the GFC as a ‘safe haven’ for income investors. Inside the annuity industry Challenger has seen exponential growth in sales of lifetime annuities since 2011 with the introduction of “the Liquid Lifetime Annuity” which permits access to capital by the investor or beneficiaries in the first 15 years.
The FSI report also made favourable references to specific annuity products such as deferred annuities, a retirement savings product that pays a regular income stream to a retiree in exchange for an upfront investment. However, such ‘deferred’ products have not been sought after in recent times due lack of tax effectiveness. This might soon change.
The government announced during the budget that from July 1, 2014, deferred lifetime annuities will receive the same concessional tax treatment that superannuation assets which support income streams receive.
In today’s feature I want to look at annuities against contemporary alternative strategies .
All about annuities
Annuities can provide investors with an assured income stream, especially in retirement, by blending the capital return from the initial investment with an income payment. This makes them an efficient way to consume capital within the lifetime of the investor.
There are three main annuity providers that are issued by the life company subsidiaries of Challenger, Commonwealth Bank of Australia (Comminsure) and Westpac (BT’s Super for Life).
Life insurance companies are closely regulated and monitored by Australian Prudential Regulation Authority (APRA), not unlike APRA’s close scrutiny of the banks. Although there is a guarantee by the issuer that you will receive your promised income, this is not a guarantee by the Australian government like the guarantee attached to term deposits (up to $250,000). But the likelihood of a failure by an insurer is relatively low due to the stringent regulatory environment.
The five important things that you should know about annuities are below:
1. What is annuity? An annuity is a financial product that requires a lump sum investment up front and is guaranteed by the life insurance company to provide a fixed income stream for the lifetime of the investor, or for a fixed term. They can vary from one year up to 50 years.
The age pension is similar to an annuity, as the recipient receives a fixed income payment on a regular basis that is not subject to fluctuations based on financial markets – subject to eligibility. Some annuities can be tailored to meet the characteristics required by the investor, such as a fixed term or indexation (to inflation.)
2. The mechanics of an annuity: The investor pays the provider a lump sum and the provider guarantee to pay a fixed income on a regular basis for their lifetime or for an agreed term. Different options can allow you to either have a payout at the end of the end or for the capital to be completely used up and no repayment is required.
If the annuity is to be a lifetime annuity there are options (for a cost) that allow your beneficiaries (if you die within that period) to receive a lump sum payment earlier.
3. The costs: The costs involved are difficult to separate from the annuity, as the provider uses complex formula that includes management fees, investment risk, and administration fees to calculate the income that will be paid as the promised return on the lump sum paid up front.
Transparency is one of the major issues with annuities and it is difficult to compare what you are receiving based on performance and costs. But as long as the investor receives the agreed income stream the disadvantages of not knowing the costs are less.
When applying for an annuity, it is imperative to read the Product Disclosure Statement (PDS), which outlines most of the costs and how they impact the returns. A financial adviser can assist with this, and if the application for an annuity comes via the financial adviser then a fee will be paid by the provider to the adviser.
4. The advantages: If you would like to remove the uncertainty about how to provide enough income for living in retirement, an annuity can increase the reliability of your income and ensure you do not outlive your superannuation balance. A more common option is to roll over your superannuation balance once you enter the pension phase and the annuity pays you an income for your lifetime or the term agreed on.
The benefits come in the form of minimising financial market risk (volatility and uncertainty of returns), inflation risk (if you buy an indexed annuity can prevent erosion of the capital value) and longevity risk (running out of money before you die).
5. The disadvantages: As mentioned already, transparency with respect to cost can be considered a disadvantage. It is difficult to do a comparison across products as each provider will quote a certain return based on a lump sum investment – and how the costs impact the return and benefit the provider are not always clear.
The transparency of the investments may also be a concern as the provider is unlikely to issue a statement of your investment holdings as would be the case if you were in an account-based pension.
But the conservative nature of the return that is paid means that it is most likely that the majority of the investment will be in fixed income products – which pay a lower return but with less volatility compared to shares. The amount invested in growth assets such as shares is what will provide the return to cover the costs incurred by the providers.
A lifetime annuity transfers control of the investor’s money to the provider so it is no longer the investor’s money and any residual capital left at the end (after your death) will not be paid out to beneficiaries, unless the annuity includes the provision for return of residual capital.
Are annuities good value?
An investor who would like to protect their capital may find annuities not as attractive as a fixed term deposit, especially after taking into account the costs such as the management fee or upfront fees to advisers and/or trailing commissions.
Lifetime annuities have more flexible options than they have had in the past such as indexation to inflation, capital repayment if the investor dies prematurely, or even the investor receiving the capital back earlier – but the cost of flexibility is a lower rate of return in the form of a lower income payment.
Annuities or account-based pensions?
Some of the choices to be made on entering the retirement phase can include whether to receive a lump sum and invest in an annuity, or invest in an account-based pension.
In table one below are the comparative risks for each option relative to different scenarios. The differences between each type of investment are determined by the length of the investment (lifetime annuity versus no fixed term for an account-based pension); the flexibility of withdrawals (no flexibility for lifetime annuities or more flexibility, subject to the minimum withdrawal, for account-based pensions) and early death of the investor (depends on the type of annuity or whether a binding death nomination has been made for the account-based pension).
A lifetime annuity can boost income provided by other sources. An income of $58,000 is required by a couple to live comfortably in retirement according to the Association of Superannuation Funds of Australia (www.superannuation.asn.au).
If the balance of their superannuation fund at retirement is $800,000, then $100,000 could be invested in an annuity indexed to inflation and with the option of redeeming within 15 years, paying a return of $4,069 annually or a nominal return of approximately 4.1% per annum (see table two).
The balance of $700,000 could be invested to pay a return of $54,000 a year until the investors reach 84 years old – if allocated to a balanced fund that has 50% invested in shares and 50% in cash or fixed interest securities.
The account-based pension looks relatively more attractive as the nominal return is approximately 8%, but there is no guarantee that the annual payment of $54,000 will be paid to the age of 84 years old if the investment falls in value (depending on the returns from shares and fixed interest investments).
In contrast the annuity is a guaranteed return, regardless of the market’s performance.
Annuities have their place in a retirement strategy, or even before retirement if the lower rate of return is acceptable to the investor. The guaranteed income option is attractive but other considerations need to be taken into account, such as comparable fixed interest returns, the opening capital amount required to achieve a certain return, and the willingness to lose ownership of some or all of your capital.
Annuities can provide a safeguard against future adverse market events (such as the global financial crisis). Account-based pensions have more flexibility, with respect to drawdowns and future capital growth.
A combination of both in retirement phase would make a lot of sense.