PORTFOLIO POINT: With the options of choice of term and frequency of payments, annuities might suit investors seeking reliable income.
Retirees have several competing objectives, but their main concern is to ensure their capital lasts their lifetime. The turbulent post-GFC investment markets have left many budding self-funded retirees wondering whether their capital will last, or whether they may have to fall back on to the age pension safety net. Could this be the reason why once-popular annuities are making a comeback?
There was once strong demand in Australia for annuities, fuelled by favourable Centrelink treatment that made these products assets test-exempt. However, the removal of this exemption saw a decline in demand, until now. The new annuities on the market offer greater flexibility to counter some of the concerns about their predecessors.
In simple terms, an annuity is a contract between an investor and a financial institution or life company whereby the investor pays a lump sum upon retirement to the institution in return for an agreed (guaranteed) revenue stream from the institution for an agreed period.
The word “guaranteed” needs to be qualified. The income stream is guaranteed insofar as the counterparty (being the institution you have a contract with) remains financially healthy. This counterparty risk is one of the disadvantages of annuities.
The terms and conditions of annuities differ depending on the provider; so the product disclosure statement for the particular annuity should be considered carefully. Modern annuities offer a vast array of flexible options, including choice of term (anywhere from one to 30 years or lifetime), frequency of payments (monthly, quarterly, or annually), indexation of payments and potential early withdrawal under certain circumstances.
Elimination of market risk. By purchasing an annuity you are able to transfer investment market risk to the annuity provider. Therefore, your future income generation is no longer dependent on market performance. This is particularly useful during volatile times.
Elimination of longevity risk. With a lifetime annuity, the uncertainty surrounding the longevity of your retirement capital is removed.
Ease of management. Once the annuity is purchased there is no ongoing management in relation to this portion of the investment capital.
Tax effective. Income from annuities purchased with superannuation money is tax-free to those aged over 60.
Lack of control. You have no control over the underlying investments in which the lump sum is invested. However, I would argue that given you are receiving a guaranteed income then lack of control should not be an issue.
No capital to be left to the estate upon death. Annuities work on the concept of pooled risk, whereby those annuitants who pass away earlier forfeit the remainder of the lump sum and consequently subsidise those who live longer. Most annuities have no residual capital value, meaning that if you were to pass away prior to the expiry of the annuity term, then you forfeit the remaining capital value of the initial lump sum invested.
No participation in market upside. The guaranteed nature of the income stream eliminates the fluctuations within the investment markets – both up and down. You will not enjoy any upside in market movements once the annuity is entered into. This is the trade-off for the certainty of future income.
Invested capital is tied up for the length of the annuity term. Modern annuities do offer some flexibility with respect to this issue. Certain products offer the option of breaking the term and exiting the annuity prior to maturity.
Lower ongoing income. The annuity provider bears all of the market risk and longevity risk under such an agreement. Therefore, to compensate for this it will generally use conservative assumptions when setting the annuity payment levels and tend to pay a lower ongoing income compared to other investments for a given level of capital. The rate of income is dependent on a number of factors such as the term of the annuity and frequency of payments.
How can annuities be used in your portfolio?
As with any investment, the strategy is based on your risk profile and investment objectives. Those who are nervous about investment market volatility, have a conservative risk profile and are prepared to accept the trade-offs that come with the elimination of market and longevity risk, can opt to have all of their investment capital invested in an annuity.
The investment term can be altered to suit individual objectives. If the desire is to have a guaranteed income for life then a lifetime annuity can be purchased. If the objective is to see off the volatility over the short term and take control of your investments once there is more clarity in the global economy, then a five-year annuity might suit.
Another strategy is to hedge your bets by allocating just a portion of your investment capital towards an annuity. In essence, it is treated like another investment within your portfolio. You may choose to allocate a defensive portion of your portfolio to an annuity and retain control over the growth component by investing that separately. This strategy provides guaranteed income from a portion of your portfolio while still providing you with an opportunity to participate in future market growth.
Utilising annuities brings to the fore some competing objectives such as managing longevity risk whilst leaving a legacy for your estate. Careful consideration must be given to the pros and cons of these products as they relate to your personal circumstances and the best product with the most appropriate terms and conditions.
Prabath Ekanayake is an adviser with Lachlan Partners Wealth Management. This article first appeared in The Investing Times, and is reproduced with permission.