27 April 2011

Ageing with annuities

With benefits including higher potential earnings, tax efficiency, and a secure long-term income stream, annuities are a popular retirement income option.

Objective

To receive a regular fixed income for a fixed term, or for your lifetime, in exchange for an upfront payment.

Fundamentals

An annuity is a financial contract, usually an insurance contract, where the seller provides the buyer (annuitant) with an income stream in exchange for an upfront payment (or series of payments made before the income payments start).

Popular as a retirement income strategy, annuities can befor a specified term (for example, one to 30 years), or for the lifetime of the annuitant.

Annuities can have a fixed, guaranteed rate of return (for example, 6 per cent per annum) or a variable return linked to the performance of a market index or investment fund. Income payments can also be set to increase in line with the rate of inflation.

Fixed term annuities

Fixed term annuities aresimilar in many ways to an investment in a bond or termdeposit. They are tailored by specifying both the term of the annuity and the amount to be returned at the end of the term, called the residual capital value (RCV).

The RCV can be anything from zero to 100 per cent of the original investment, and is set by the investor at the start of the annuity. If an RCV of less than 100 per cent is selected (that is, at the end of the term the annuitant receives less than they originally invested), then income payments comprise both the earnings from the investment, and the return of the original capital.

At the end of the term, any RCV is returned to the investor, and income payments cease.

Lifetime annuities

With lifetime annuities, there is no term or RCV specified, with the income stream continuing forthelife of the annuitant.

Unlike a fixed term annuity, where the annuitant assumes the risk that they will live longer than their income will last, lifetime annuities shift this longevity risk to the insurer.

Strategies

Annuities are primarily used to generate income in retirement,and can be compared to other retirement income strategies suchas bank deposits, allocated pension products and other incomegeneratinginvestment strategies. The benefits of annuities caninclude:

  • Higher earnings. Annuities generally offer better rates than many other fixed incomealternatives (such as bank deposits and government bonds),as they are issued by insurance companies, which tendto have lower credit ratings and therefore offer higher yields.
  • Guaranteed returns for very long terms (30 years or more). Annuities can offer longer investment terms than are usually available from banks andbonds in the Australian market.
  • No risk of outliving your savings. Usinglifetimeannuities, the insurance company assumes your longevity risk, which means your income continues as long as you live.
  • Capital growth potential and inflation protection. Market or inflation-linked income streams can provide capitalgrowth or inflation protection that may not be explicitlyprovided in other retirement income products.
  • No management fees. Fees are incorporated into the annuity rates offered.
  • Tax efficiency. Income can be tax-free in Australia if the annuity is purchased with superannuation money and the minimum income payment requirements are met.
  • Relatively simple and flexible.

Risks and considerations

Because annuitants are reliant on the insurer continuing to make income payments (that is, they take on the credit risk of the insurer), it's important to ensure that the annuity provider is well rated by ratings agencies and is properly regulated.

In Australia, life insurers areregulated by the Australian Prudential Regulation Authority. This ensures that the insurers are well capitalised and holdsufficient liquid assets to meet expected annuity and deathbenefit payouts.