Investment Road Test: Challenger Annuities

PORTFOLIO POINT: Annuities add certainty to retirement planning, but they do come at a price.

Investors are still spooked about the global and Australian stockmarkets, and the high rates offered by Australian term deposits are attracting a rush to their certainty of capital security and high levels of income.

The problem for long-term investors is that inflation and taxes erode the value of term deposits. Post retirement, the tax on earnings from term deposits, if they are held inside a super account, is generally nil – but for most investors looking for a tax-free income stream in retirement, annuities will be the best option. Challenger has been promoting its range of annuities under a campaign that highlights how frequently investors may experience the adversities of a market crash:

Annuities have been around for a long time, and in the Australian market they can only be issued by a regulated life insurance company. That is because the underlying investments are managed in such a way as to build reserve funds out of which the ongoing commitments are paid to investors – and it’s the maintenance and calculation of these statutory reserve funds that is regulated within the life insurance vehicle providing the annuity.

Well-advised SMSFs can create their own complying annuity framework but this is typically a complex process. Non-SMSF investors often find that using an externally manufactured annuity is the simplest way to access the certainty they provide.

Annuities typically come in two main forms: either with fixed terms, or provided as a lifetime investment product. Some annuities offer CPI indexation, and there are various forms of flexibility regarding early termination of the annuity (known as “commutation”).

Challenger provides a wide range of annuities, with a focus on fixed term or lifetime annuities. Although it doesn’t specify in detail how it hedges these investments, it does state (in line with typical arrangements used in the annuity market) that it invests into fixed income, property and infrastructure assets (typically the latter would be into the debt components of these assets). Management fees are recouped from the overall investment returns, not from individual investor’s accounts.

Although this style of investment is not without risk, the volatility of these returns is normally less than from equity markets and, in combination with conservative reserving and monitoring within the insurance framework, this leads to the relative certainty offered by annuities. Investors do need to be aware that annuities are not capital-guaranteed by their issuers, and so there is still some risk of default (although regulation and conservative investing makes this risk highly unlikely in practice).

In superannuation, investors can buy annuities after reaching the age of 60, and payments made to the end investor from the annuity will be tax-free. The purchase of the annuity has to be routed through the super fund to ensure this tax treatment. Challenger’s fixed-term annuities are for a range of terms from one to 50 years and allow for a choice of a full return of capital at maturity, or for a return of some or no capital at maturity.

The current rate sheet for Challenger fixed-term annuities shows a good return of 5.53% pa for a one year term fixed annuity with 100% residual capital value, and for the CPI linked annuity with a two-year term, the rate is 5.77%. These rates compare favourably with one-year term deposit rates, the best of which currently on offer is from Rabobank, which offers 6.4% for a one-year term deposit.

Challenger also offers interesting “Lifetime” annuities – with the following indicative returns for $100,000 invested at age 55 (returns payable annually):

It is clear that the rates offered for Lifetime annuities are lower than available in the term deposit market – but it’s here that the most interesting opportunities for retirees can be seen. The problem with term deposits is that rates fluctuate and penalties for early withdrawal in long-term term deposits can be significant. And while equity markets do recover after crashes – and quality stocks do tend to continue to pay good dividends even during market crashes – the sharemarket does tend to be problematic for retirees looking for stable income streams in retirement.

Many SMSF retirees are now faced with the reality of having to sell down a part of their share portfolio far sooner than anticipated to generate the income they need to use in retirement. This obviously leads to a bigger problem over the longer term: selling stocks sooner and at lower prices than hoped for, reduces the size of the portfolio and the income that arises from it – and hence compounds the need to keep selling stocks going forward.

Using the indicative rates provided by Challenger, the return of a lifetime commutable pension for an investor aged 55 is 30% less than available through a one-year term deposit. But the flipside is that the return from the annuity is locked in for the life of the investor, no matter what happens to markets during the period.

“Commutation” means the flexibility to terminate the annuity and to be paid out its current value in full; so investors looking for more certainty at lower opportunity cost in comparison to term deposits could choose the “non commutable” option, where the residual value of the annuity policy is paid out upon the death of the annuitant (ie, for the benefit of the annuitant’s estate).

The return for the Challenger “non commutable” lifetime annuity at current rates is only 19% less than offered for the one-year term deposit – with the benefits of certainty compensating for the gap in returns.

Given the high likelihood of future market crashes, annuities provide a good return with certainty and should be considered as a key part of most investor’s retirement portfolios. But the single-digit returns highlight the need for investors to build a large capital base for retirement – and the sooner this starts, the better.

The score: 3.5 stars
0.5 Ease of understanding/transparency
1.0 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.