Cracking the annuities code: get retirement income certainty

Annuities are a financial product that have fallen out of favour. An annuity offers a different kind of certainty for people looking for retirement income without riding the wild rollercoaster of share markets or other investments.

By Nigel Bowen

How does a 100% guaranteed income stream, potentially locked in for life, sound?

The biggest retirement income issues come back to one question – how do you fund the retirements of increasingly long-lived people? Part of the solution may be encouraging retirees, and soon-to-be retirees, to invest in annuities. 

You may never have even heard of the financial product known as annuities. They are sometimes called ‘fixed-term pensions’ or ‘lifetime income products’ but essentially they are contracts between a person (or a couple) and a financial institution.

Even if you have heard of annuities, you’ve probably never considered buying one. 

As Australia’s Treasury experts say:  “In Australia, only 3.5% of assets held in pension accounts are in annuities, while 84% were held in account-based or allocated pensions. Retirees can be reluctant to purchase annuities: a reticence that is not unique to Australia.”

The mechanics of annuities work like this:

You give me a certain amount of money now and I pay you back that money, with a little extra added on top, over time. 

Annuities typically come in 3 different shapes and sizes:

1. Fixed annuities

These provide a predetermined, fixed interest rate for a specified period. They offer stability and guaranteed returns.‍

2. Variable annuities

The returns on variable annuities are tied to the performance of underlying investment portfolios. This means the income can fluctuate based on market conditions.

3. Indexed annuities

These are a mix of fixed and variable annuities linked to a stock market index, for example, to give potential for higher returns while also offering a level of downside protection.

Interest rates, and interest in annuities, up 

You buy annuities as an investment product (often from your accumulated superannuation) and pay a lump sum upfront to guarantee income for a fixed term, such as 10 years, or even for life. You can also buy annuities as a couple and leave the annuity to your partner should you die before them.

For instance, you buy a $100,000 annuity from a financial institution today and they pay $10,000 annually for the next 12 years. This is a purely hypothetical example, but there are plenty of ‘annuity calculators’ online if you want to get an idea of how much annuities cost. 

(While you’re keying numbers in, you may also like to check out all the retirement-income-related calculators available here.)   

With the post-GFC zero-interest rate period (ZIRP) era long gone, annuities have been offering more attractive returns. To continue with the hypothetical example above, that might mean putting down $100,000 now means I get a $10,000 payment for 15 years rather than 12.

Governments in ageing societies are hoping rising interest rates may encourage people to give more consideration to annuities. 

An Australian Treasury official recently observed, “The lack of annuitisation by retirees globally, despite the commonness of the concern about outliving one’s savings, is known as the ‘annuity puzzle’.”

The Australian government is reportedly so keen on greater “annuitisation” that it’s encouraging super funds to offer a greater variety of annuity products and even considering selling annuity-like ‘longevity bonds’ itself.

Generally, annuities bought with superannuation money are tax-free from age 60. Annuities can also be bought with superannuation money before the age of 60, which means there is likely a taxable portion taxed at your marginal tax rate (along with a 15% tax offset).

It’s important to get financial advice from your super fund, an advisor or an accountant or lawyer to understand if these products are right for you. Read more about how retirement income works on Citro.

How annuities work

You don’t have to be approaching retirement to buy an annuity, but that’s when people usually take an interest in them. 

The upside of annuities – and their downside – is that they are the ultimate low-maintenance investment. You don’t need to worry about what’s happening with the share market, property market or wider economy, because you get your agreed payment regardless of the economic conditions.

A lifetime annuity works similarly to a pension, in the sense you get a set payment for as long as you are around to collect it. 

Account-based pensions also typically involve a set payment that arrives monthly, quarterly, half-yearly or yearly. But that pension is being paid from the super money you have accumulated – once the funds are exhausted, the payments stop.  

Given compulsory super has only been around since the 1990s, many Australians still don’t have large balances and can’t rely on an account-based pension – or a lump-sum withdrawal, for that matter – to finance a retirement that could last several decades. 

But they may have enough money to purchase an annuity. This “annuitisation” of their retirement income could make their retirement more comfortable, or at least less anxious, and delay or obviate the need for them to claim the Age Pension.

The Australian Government has long incentivised the purchasing of annuities. 

For a start, you don’t need to find the money to buy an annuity, you can just use money from your super account once you hit preservation age (60 if you were born after June 30 1964). Also, payments from an annuity bought with super money are tax-free after 60.  

On the other hand, any payments you get from your annuity are included in the income and assets test to determine your eligibility for a full or part Age Pension. 

(So, it may make more financial sense to use money you would have otherwise invested in annuity to pay off your mortgage, given the value of your primary residence doesn’t impact your pension eligibility.)      

The different types of annuities

An array of annuities is already available. Both private businesses and maybe even the Australian Government could launch even more annuity or annuity-like products as our populations gets older. 

There isn’t space in this article to cover everything, but please be aware of the following.

1. Lifetime annuities are interesting: 

You can buy a “life-expectancy” annuity that will pay out until you reach the length of the average lifespan (for someone like you). 

And you can buy a “lifetime” annuity that will last as long as you do. 

Any type of annuity can provide peace of mind, but be aware that the more serenity you want, the more you’re going to have to pay for it. 

All else being equal, a lifetime annuity will be more expensive than a short fixed-term one.

2. Annuity payments can be indexed to inflation: 

You may be wondering what happens if inflation means your payments end up being less impressive than expected, especially many years after the annuity was purchased. Fortunately, you can buy annuities that are either indexed to inflation (that means if inflation goes up 5%, your payments go up 5%) or that increase by a set amount – for instance, 3% – every year.

3. You can bequeath your annuity payments: 

What happens if you fall under a bus the day after investing your entire nest egg in an annuity? That will depend on what type of annuity you’ve purchased, but you certainly can opt for annuities where a nominated beneficiary, known as “revisionary” or “revisionary beneficiary”, gets your payments if you are not around to collect them. But be warned, they’ll often receive lower payments than you would have.^[iii]

4. You can buy annuities alone or with a spouse:

The upside of buying an annuity with a spouse is that it allows for income splitting for tax purposes. In the case of an annuity bought in joint names, the surviving spouse takes full ownership if their partner passes away.   

 A handy backstop?

There are no guarantees in life, but an annuity comes close. 

Barring exceptional circumstances, once you’ve bought one you can be sure of receiving a set amount of money for a set amount of time. 

So, if you know your fixed costs in retirement – groceries, insurance premiums, utilities, vehicle expenses – are going to be, say, $20,000 a year, you may want to consider investing in an annuity that pays out around $20,000 annually.

But retirement income streams are rarely an all-or-nothing proposition. 

Many Australians already mix and match with lump-sum withdrawals and account-based pensions. In future, more of us may choose to add annuities to the mix as well.

There’s no shortage of advice, much of it free, available for those who want to learn more about annuities.

To learn more, contact your super fund, speak with a Financial Information Service officer (from Services Australia), or consult with a licensed financial adviser.

_{Advice given in this article is general in nature and does not take into account your personal circumstances. It is not intended to influence readers' decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.}