The annuity products with variable benefits

Annuity products provide a fixed income stream … but some are much better than others.

Summary: Annuity products provide a fixed income stream in retirement, but the best ones are market linked to the performance of managed funds or other assets. Read the fine print though. Not all annuity products are the same.

Key take-out: Recent proposed super tax changes have now been shown to have a potentially harsher impact on SMSFs, which are the most tax-effective vehicle for annuities products.

Key beneficiaries: SMSF trustees and superannuation members. Category: Superannuation.

Annuity providers like Challenger are successfully highlighting the prospects of further market crashes during retirees’ lifetimes.

The powerful imagery reinforces the need for investment certainty – noticeably lacking in managed fund products that rely on a benchmark aware approach (tracking sharemarket indices, thereby rising and falling with the market). Traditional annuities that pay a fixed return for a fixed period do provide certainty and can be a great tool for retirement.

But because that certainty comes with an opportunity cost (they don’t increase returns when markets rally), annuities aren’t ideal for retirees who have under-provided for their retirement. For them, upside potential is needed to help boost returns in the hope that retirement incomes will be adequate. Enter the world of the “variable annuity” – market-linked investments with a minimum annual income but with upside linked to selected assets or managed funds.

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.

Variable annuities extend the concept in a number of ways. Current providers include One Path (previously ING), Macquarie and AXA (now AMP) – these provide annuities, which are known in the industry as “guaranteed minimum withdrawal benefit for life” products (GMWB for Life). Challenger provides a different style of product, known as a “single premium income annuity” for life product (SPIA). The GMWB products provide a fixed minimum income payment with upside linked to the performance of market-linked funds, which can be selected by the individual investors. But they suffer from the problem that the minimum returns aren’t indexed to increase with inflation. That means that in real terms the fixed returns decline in value over time. The Challenger SPIA product has a different drawback, since the income payments cease after 15 years. As such, they are hard to use as part of an estate planning strategy. That being said, each of these products provides advantages compared to traditional fixed-rate annuities, so let’s look at some detail on them.

Each GMWB product pays a fixed annual income payment for the term of the investor’s life. Additionally, the investor can select for that payment to continue for the term of their spouse’s life, after the investor’s death. They use a fairly simple mechanism to calculate the amount of the income payment – using a fixed income rate, which is then multiplied by the capital value of the account (known as the income “base”). The fixed income rate ranges from 4% pa to 6% pa (depending on which product is chosen and the age of the investor when they take out the product). The rate is set at the outset of the product and increases with age (i.e., the older you are when the product is purchased, the higher that rate will be – reflecting that based on actuarial tables for life expectancy, older investors will have less time to live, hence allowing for higher payments to be made).

The income “base” is calculated at the anniversary of the investment commencing and is linked to the value of the portfolio of investments that are selected at the outset of the investment. The income “base” can increase if the underlying investments perform well. Each of the available GMWB products locks in the “high water mark” level of the income “base” – i.e. having increased, it can’t then fall below that level. Alternatively, if the income “base” falls during the term of the product, a minimum fixed amount is payable. The chart below shows how this works in the case of the One Path “Money for Life” product.

Selecting the right product

Selecting the right product is an area of concern for investors. Beware if the menu of available investments is limited to traditional actively managed funds, which typically fail to beat the returns available from simple index investments. The Macquarie Lifetime Income Guarantee product offers some innovative investments, to overcome this concern, including international index funds as well as funds which are “volatility controlled”. That is, they contain an inbuilt mechanism that winds down exposure to risky assets when market volatility rises (thereby avoiding the riskiness of market crashes). Similarly, the One Path Money for Life product has a menu of index fund products. Check the menu of available investments carefully before buying one of these products!

Note that in each of the products, the income “base” is measured after deduction of all the applicable fees and charges. These can be significant and are one of the sources of concern when these products are assessed. Overall fees may be upwards of 3% pa, depending on the choice of provider as well as the options selected (e.g. continuation of income payments to spouse after the investor’s death).

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. Care therefore needs to be taken with how your estate is set up, if the spouse option is selected. SMSFs can provide a flexible mechanism to allow you to tailor your estate, taking account of the assets held in the SMSF including the annuity product.

Both sides of politics should take note of this point. Recent proposed super tax changes have now been shown to have a potentially harsher impact on SMSFs and, to the extent that SMSFs are used to help improve estate planning outcomes, the new tax rules are an unfair disincentive to their use.

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services. He is also a portfolio construction manager for BetaShares.

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