If you are about to retire, you’re probably questioning whether super – as tax-efficient as it might be – is too exposed to highly volatile share markets to deliver dependable retirement income.
Account based pensions (ABP) linked to a super fund are the go-to retirement income solution for most retirees.
However, if you are worried about your super’s exposure to highly volatile share markets or simply suffer from FORO (fear of running out of savings in retirement) why not consider outsourcing some of your retirement income to an annuity provider?
Despite being complex investment vehicles that most retirees struggle to understand, annuities may still look relatively attractive, especially given the Reserve Bank’s (RBA) reluctance to cut rates.
What is an annuity?
An annuity is simply an ‘olde worlde’ term for a product where you hand over a lump sum to a financial services provider, and in return, they guarantee to pay you an income stream.
One way to look at annuities is as ‘reverse life insurance’.
That’s because members of the (annuity) pool who live longer end up being subsidised by those with shorter lives.
Given the fear of running out of money in retirement (FORO) – aka longevity risk – is something most retirees worry about, the idea of having an income for life may have merit, especially if longer life spans run in your family.
The higher payments afforded by what’s called ‘pooling’ make a lifetime annuity more attractive, by generating an additional level of income that other defensive assets struggle to match.
Despite their promise of a guaranteed income for life, a recent University of NSW study suggests that over half (57%) of Australians have no knowledge of annuities.
Certainty of income
While there’s no guarantee the returns will match growth assets, the beauty of annuities is that they provide certainty of income, regardless of what interest rates or share markets are doing, and without additional fees.
Equally compelling for lifetime annuities and 100% capital return annuities – with terms of six years and above – is the more favourable treatment they now receive under Centrelink asset and income tests for the age pension, daily aged care fee subsidies and the seniors’ card.
How annuities work
Unlike most account-based pensions, share market performance doesn't affect annuity returns.
As a result, annuities are typically regarded as one of the more stable retiree investment options.
Annuities can only be provided by life insurance companies, and these companies are regulated by the Australian Prudential Regulation Authority (APRA).
However, they are generally marketed by broader financial organisations, and some of the companies offering annuities include Challenger, Generation Life and AIA - with Challenger having a dominant market share of 75%-plus.
It’s APRA’s job to ensure providers maintain sufficient capital to meet their obligations to retirees, even during extreme market events.
Other key benefits
The income from super-paid annuities is typically tax-free once you hit age 60, and there are three options to choose from.
Firstly, there’s a lifetime annuity, which pays a regular income stream for the rest of your life, even if you live to 110.
By comparison, term-certain annuities are meant to be held for the duration, and have fixed start and end dates (one to 50 years).
Under this option, you get to choose whether capital is returned at the end of the term or gradually as part of the regular payments.
Then there are “reversionary” annuities which allow you to continue the payments for the lifetime of a second person – either in full or partially – after you die.
Alternatively, you can choose the guaranteed period option, which means that if you die within the specified guaranteed period, your beneficiary will receive remaining income payments as an income stream or lump sum.
However, you can also use savings to buy an annuity in joint names.
This allows income splitting for tax purposes.
It also means that if you or your partner dies, the survivor has ownership and access to the funds.
Potential downsides
It’s highly unlikely, given the sheer size of the financial institutions in the annuities space, but there’s always the underlying risk that the company issuing the annuity will go bust.
One of the major drawbacks to annuities is that you need to live to a certain age (ABS figures, 80.5 men and 84.5 women) for them to be worthwhile, relative to alternative investment opportunities.
It’s also worth noting that unless you choose the indexed option, inflation will eat into your return.
So while locking in a fixed income provides security, it can result in reduced buying power if prices suddenly kick up.
However, inflation-linked options include Challenger's CPI-linked annuities, which adjust payments in line with inflation and pegs the returns to the RBA cash rate.
Additional benefits & withdrawal options
Certainty and stability of income aside, there’s growing pressure on annuity providers to ensure the investment isn’t lost if you die early.
For example, a common concern among retirees considering annuities is the fear of losing their investment if they pass away shortly after purchasing the product.
Some providers now address this by offering additional benefits or withdrawal options.
For instance, Challenger's Liquid Lifetime annuity now offers a death benefit period based on the retiree's life expectancy.
For a 65-year-old male, the death benefit period is nine years, while for females, it is 11 years.
The product also allows investors to withdraw their funds during an initial period if their circumstances change.
Challenger's Liquid Lifetime option, along with other products such as Generation Life's LifeIncome, allows the income stream to be transferred directly to beneficiaries.
Exposure to annuities
While annuities aren’t for everyone, a growing number of advisers recommend them as just one of many components within a diversified retirement portfolio.
Aaron Minney, head of retirement income research at Challenger, suggests most Australians can enjoy key annuity benefits with a capital allocation of between 20-30%.
"When a retiree allocates a part of their retirement savings to a lifetime annuity, their estate balance is often higher. This is because of the regular income the annuity provides, meaning there is no need to draw down from savings,” he says.
Based on Minney’s research, lifetime annuities best complement retirees with a conservative risk profile.
"They want certainty around their investment, want to take out any investment risk, and want a guaranteed income stream.”
However, it’s also important to remember that some annuity providers (like Challenger) have moved up the risk curve in their investment selection – in response to declining yields in the fixed interest and property.
As a result, it’s critical you fully understand what additional investment risk you're exposed to - which is why it pays to seek professional advice first.
