One of the biggest challenges in investing is the transition into retirement. Walking away from your career requires confidence that you have enough savings to last for the rest of your life.

After years of building up your portfolio it is suddenly time to sell it off to pay for your day-to-day expenses.

This can invoke anxiety for even the most knowledgeable investors. Are you spending too much or too little? Is your portfolio too aggressive or too conservative? How will short-term market movements impact your retirement?

Throw in some inflation and an uncertain economic environment and a time that is supposed to be a respite from a lifetime of hard work can be fraught with worry. And yet there is pathway to alleviate much of the risk of retirement. A pathway that a surprisingly small number of investors take.

What are annuities?


Annuities offer a fixed stream of payments to an investor. This stream can be for a fixed period, or for their lifetime (lifetime annuity payments). These payments can also be linked to CPI, so you’re protected against inflation eroding your purchasing power.

Although annuities can be purchased by anyone, they are particularly popular for investors in retirement.

One of the unknowables with retirement is how long you’re going to live for, and therefore how much you will have to save to provide for yourself. This guaranteed payment, especially with lifetime annuities, offers investors peace of mind with retirement if they are receiving a regular income stream until death.

How annuities work


According to AIA (an annuities provider), the regular payments you receive will depend on:

  • your purchase price
  • the term of your annuity
  • the Residual Capital Value (RCV) you choose (if any)
  • the rates we offer at the time you invest, and
  • whether you invest with personal savings or with money from your super.

As an indicator, Challenger offers the following rates for a female investor, for each $100,000 invested:

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One of the most common questions asked about annuities is what happens to the capital after you die?

The purpose of an annuity is to give up your capital to receive guaranteed income. If you are to die prematurely (this is determined based on the age that you take out your annuity), a death benefit will be paid out to your beneficiaries. In some cases, a death benefit is a full refund of the initial premium so as well as guaranteed income, some investors consider this as insurance against premature death.

An example of this would be a retiree at 75. They would receive their capital back if they died within 10 years, on top of the interest payments that they have already received. Then, there would be a reducing death benefit that is based on life expectancy.

How annuities fit in investor’s portfolios


As an asset class, annuities would fall into fixed income.

Unlike equities, annuities are not impacted by share market movements although there are certain products where you can elect them to be linked to share market movements.

Unlike most forms of fixed income, they are not impacted by interest rates. This means that retirees don’t have to worry about issues such as sequencing risk and longevity risk – two of the major concerns in retirement.

Annuities are not meant to replace your entire income in retirement. They are meant to be a portion of your retirement strategy that provides a foundational guaranteed income, with other assets able to take on risk to drive returns. There are also concessions for holding annuities and receiving the age pension.

For income annuities that commence on or after 1 July 2019 the rules will generally assess:

  • 60% of the purchase price of the lifetime income stream until age 84, subject to a minimum of 5 years; and
  • 30% of the purchase price thereafter.

You’re able to invest in annuities through your super or as a personal investment. If it is through your super, the regular concessions apply such as tax-free earnings in pension phase.

It is also important to consider that annuities are relatively illiquid.

Unlike other instruments, you’re not able to partially sell investments. If your circumstances change and you need to access your investment, you are able to withdraw 100% of your lump sum up until a certain holding period, then, it reduces down to 0% in intervals. After the withdrawal period has ended, you will no longer be able to access your capital and you will continue to receive your guaranteed income for the rest of your life. An example of this is shown below:

annuity

Source: Challenger, Lifetime annuity for a 65 year old female

A significant consideration for annuities is whether investors want to leave an inheritance for their beneficiaries.

After the withdrawal period elapses, there is no ability for you to pull out your funds, and the capital is paid in exchange for guaranteed income. This means that for the annuity portion of your portfolio, you would have no capital to go to your beneficiaries when you die.

If you have a partner


If you have a partner, you’re able to jointly hold your investment if it’s invested outside of super. This means that you are able to split the income for tax purposes.

If one of the owners of the annuity dies, the remaining owner is able to continue receiving the funds as an income stream (at a reduced rate), or a lump sum.

What happens if my annuities provider goes bankrupt?


Annuities issuance is supervised by the Australian Prudential Regulatory Authority (APRA). They ensure that the annuity issuer hold enough cash to be able to make all of the payments to pay out the annuity.

This is stronger than the requirements for corporate bondholders. It is more than likely that the annuity issuer holds more than enough capital to pay you back. If anything happens to the company, your annuity payments need to be made to you before bond holders or shareholders get paid.

Graham Hand, Managing Editor of Firstlinks, shared his thoughts on holding annuities, including concerns about the underlying investments of annuity providers.

"A ‘term annuity’ from a life company is not like a ‘term deposit’ from a bank. The annuity is only as strong as the underlying issuer and the assets it holds. In order to pay say 5% to the investor, cover the cost of capital and make a profit, the life company will need to invest at say 7-8%. To attain this return, the assets usually include property, sub-investment grade investments and perhaps private assets which may struggle in an economic downturn.

Bank deposits are not only backed by the bank but a government guarantee up to $250,000. Personally, I would not want a large exposure to an annuity issuer for the rest of my life, as I don’t know how the underlying assets will perform for the next 20-30 years," he says.

Why don’t more Australians hold annuities?


There are multiple annuity providers in Australia, but not much uptake with most annuities purchased for clients through financial advisers.

The Actuaries Association of Australia quoted a study done by their American counterparts as to why investors don’t purchase annuities to the extent expected.

The most common answers that were given were the loss in liquidity, the loss of a bequest when they die, low risk aversion – so retirees are willing to take on more risk for return and higher personal consumption rate. Investors would rather consume their funds more when they are young and able – to travel and to enjoy life, and don’t value a steady income stream that pays them the same amount across the decades. They want the flexibility to draw down and use the amount that suits them.

As part of an overall portfolio, annuities can help investors do this.

Another interesting answer was that investors have already got a guaranteed income through the age pension, so they don’t need two sources of guaranteed income. They would rather have the age pension come in and put the money to work in a riskier asset class. This is a completely legitimate reason for foregoing annuities.

Investors that have already met their income criteria from cash and fixed income may find that annuities lower the risk of their portfolio below the range that they require to sustain their lifestyle.