Lightness of being
Annuities are making a comeback now that markets are unpredictable, writes John Collett.
Annuities are making a comeback now that markets are unpredictable, writes John Collett. Fears that the worst of the GFC is not behind us are prompting retirees to restructure their portfolios to include at least some exposure to secure-income investments.Sales of annuities and other investments in the secure-income category have increased as more retirees seek the refuge of guarantees after the disastrous returns on sharemarkets over the past three years.During the GFC and its aftermath, many retirees suffered significant capital losses. With no income coming in to top up account balances, retirees are looking for ways to restructure their portfolios to help preserve their remaining capital, or to products that ensure they will receive a certain minimum income."Peace of mind and security is what a lot of my clients are wanting, given what has happened in the last three or four years," says a financial planner with Paramount Wealth, John Goldie, who specialises in working with retirees. He has had an increase in clients calling him expressing a desire to have more exposure to cash. This follows a dip in balances of recent weeks after it seemed the worst of the GFC was behind us."Having something like an annuity that is CPI-indexed as part of the asset mix of the account-based pension for 20 per cent or so of the balance gives some surety and helps them sleep better at night," Goldie says.The managing director and chief investment officer of investment adviser Ibbotson Associates, Daniel Needham, says among the biggest risks in retirement are running out of money and inflation risk. Guaranteed income streams through lifetime annuities where the income increases with inflation, or via products with lifetime-guaranteed income, can be important building blocks in retirement, he says.ANNUITIESAnnuities are similar to term deposits and government bonds. Investors hand over their capital and, in exchange, they receive a fixed interest rate for the term of the annuity.However, annuities are more flexible. With bonds and term deposits, the original capital is returned to the investor at the end of the term. With annuities, investors can specify whether they want all of their capital returned at the end of the term, or only some returned with the rest drawn down with the periodic interest payments. The interest rate can be a flat rate paid for the life of the annuity or adjusted upwards in line with inflation.Some annuities can have a "second" life added to the annuity contract where, if the investor dies before the end of the term, a second person receives the remaining interest payments.An annuity is a life-insurance product and the issuer has strict rules on how much capital the life office has invested that is backing the future liabilities of the annuity.In reality, there is very little difference, in terms of risk, between a term deposit offered by one of the big banks or an annuity from a life office, which will often be owned by one of the big banks anyway.Most retirees have allocated pensions, which are account-based and convert their superannuation benefit into an income stream. The allocated pension will have range of asset classes from which to mix and match a portfolio suiting a retiree's objectives and tolerance for risk.The trouble with the typical "balanced" type of portfolio mix is that it usually has a large chunk of the investment in risky "growth" assets, such as shares.Many allocated pensions will have a wide menu of investments from which to build a portfolio, usually including term deposits, cash and cash-enhanced funds and, sometimes, annuities.There are only three major providers of annuities. Challenger is the largest provider, followed by the Commonwealth Bank life insurance arm, CommInsure, and Westpac.SURRENDER VALUEThe managing director of research firm DEXX&R, Mark Kachor, says annuities can be well suited to the needs of those for whom "freedom from care" is important. But investors can be at the mercy of the provider if they want to break the annuity contract.The annuity provider will set a surrender value for a lifetime annuity but how much capital is returned is at the discretion of the provider's actuary.Unlike bonds, where there is a market in which they can be sold, or term deposits, where providers have a set formula used to calculate the amount of capital to be returned, the pricing of the surrender value of annuities can be "opaque" compared with other fixed-interest products, Kachor says."That is an issue that some of the financial planning community has with annuities," he says.Needham says it is important that retirees work out how much of their capital they can live without, because they do not want to be breaking the annuity contract.Interest rates on term deposits are publicly available and readily comparable with each other, as are the rates on government bonds.Pricing information on annuities is not generally publicly available on providers' websites.Investors and planners call the provider to get a quote, which will be valid for a specified time. Interest rates paid on annuities are usually updated once a week or so as markets change.Those with self-managed super funds have even more freedom to invest their money than those in allocated pensions. A 10-year ANZ term deposit has an annual yield of 5.65 per cent with interest paid monthly, the same frequency as most annuities.DEXX&R data shows that certain 10-year term annuities with the capital returned at the end of the term pay less than the ANZ term deposit but the annuities' interest rates are subject to change quite regularly and there are big differences in the rates on offer.For example, as at June 30, CommInsure has a 10-year annuity with 100 per cent return of capital that pays 3.21 per cent and Challenger's pays 5.59 per cent (see table).The head of corporate marketing and communications for Challenger, Stuart Barton, says that the rates for Challenger's annuities shown in the table are even higher now than in June because, in anticipation of new laws banning commissions, Challenger removed planner commissions from its annuities. He says its 10-year annuity with 100 per cent return of capital is paying 6.5 per cent.GOVERNMENT ANNUITYThere is likely to be a new player on the annuities scene in the form of the NSW government. It is planning to launch an annuities product in the next few months.The annuities will be inflation-protected and will have a term of between five years and 10 years. Details of the annuity are being kept under wraps but it is expected to be simple, without the flexibility of the annuities offered by commercial providers. It is believed that the annuity will have standard surrender levels that will be known before the annuity is purchased.Needham says an annuity provided by the NSW government would be a good thing."I think it is great it will be a complement to traditional assets and a complement to lifetime annuities," he says.Most of the annuities being sold have terms of less than 10 years. Retirees still seem reluctant to lock their money away for longer terms, especially into annuities where, if they die before the term ends, there is nothing left for the estate.The Henry review of Australia's tax system said that any money that was put into a deferred annuity, which is one that starts paying income sometime in the future, should be exempt from social security assets-and-income tests. If the government supported the idea, it would be a way of helping to give security in advanced old age.For a relatively small outlay at, say, age 65, the retiree would get an inflation-adjusted income when they turn 85, for example, for the rest of their life.Ultimately annuities - especially those that run for life - are insurance products and the investor is taking a bet against the life company that they are going to be living long enough to enjoy the income.Unlike with allocated pensions, on death, there is usually nothing left over for the estate.Anyone considering the products needs to be careful because investing in annuities can also affect social security benefits.Hybrids with a twistA couple of products are available where the capital is preserved and, later in retirement, there may also be a guaranteed minimum income that is paid for life.ANZ owns an income-guaranteed variable annuity called MoneyForLife though its OnePath investment platform after acquiring most of ING's Australasian businesses. The income can grow when markets are up but will not decrease below a certain minimum when markets turn bad. Investors have access to their capital at any time but withdrawals will lower the guaranteed minimum income.AXA's North products, which are now owned by AMP, have the option of a capital guarantee where, if markets have done well, the investor retains the capital growth. A limited percentage of the capital can be withdrawn each year without affecting the guarantee.The income guarantee works like an annuity. If an investor retires at 65, AXA guarantees to pay 5 per cent of the capital each year for the rest of their life. If the account's capital value rises, AXA provides 5 per cent of the higher amount.The fees on financial products that have insurance-like elements such as guaranteed income or capital and the flexibility of capital drawdown are higher than simpler retirement products without guarantees.There is also the question of complexity. The way these hybrids work can be difficult to understand.Not at the mercy of the marketsTom Dalton loves messing about with old boats. He built a boat for himself and for the past decade has volunteered at the National Maritime Museum helping to restore old vessels. He also volunteers for NSW National Parks by leading walks and helping out in the office. "I have a few skills in a lot of areas," the 77-year-old says.When the former general manager of a metal manufacturing business retired at 65, he and his wife sought financial advice, made a budget and worked out how to proceed. However, during the sharemarket downturn in the early 2000s, the couple lost about 30 per cent of their capital.It wasn't easy to get another planner. One said the couple did not have enough money to be a client another didn't turn up for the appointment.They found a planner they were happy with at Ashman Financial.The planner spoke to the couple about what they wanted and devised a plan. The strategy was to have some of the money in annuities and the rest in an allocated (market-linked) pension.The annuity pays a set interest rate until the term ends in 2018 and the allocated pension is invested conservatively. "The annuities ensure that the vagaries of the market will not kill us," Dalton says. "We are preserving as much of the capital in the allocated pension as we can, so that when the annuity runs out we will still have money left in the allocated pension."