Article written for The Australian – Annuities in demand as uncertainty rules
VOLATILE sharemarkets and general uncertainty in global conditions are contributing to an increase in the use of annuities.
The largest provider of annuities in the Australian market, Challenger, has reported a 56 per cent rise in sales this year and forecasts another 25 per cent rise next year.
The word “annuity” was derived from the Latin word “annuus”, which means “yearly”.
During the Roman Empire, Roman citizens would make a one-off lump sum payment to the Emperor and enter into an “annua” in exchange for a lifetime of annual payments.
Today annuities are predominantly used by retirees, providing a guaranteed, regular income stream for a set period of time from one year to 50 years or even for life.
A reversionary annuitant is also an option, so if the spouse who was receiving the annuity passes away, the surviving spouse can continue to receive the annuity payments for their lifetime also.
Annuities are quite a simple product to understand. The investor gives part or all of their retirement savings to the annuity provider. In exchange, the annuity provider agrees to pay back the lump sum with interest over a set period of time in regular amounts.
The investor has the option to choose whether the whole lump sum is repaid over the period (0 per cent residual capital value), choose to be only paid the interest earned on the capital and have the whole lump sum repaid at the end of the term (100 per cent residual capital value) or choose somewhere in between. The interest rate is locked in for the life of the annuity at the beginning and is currently 5-6 per cent.
Lifetime annuities are an interesting proposition as they are a gamble on the investor’s health. These types of annuities are based on life expectancy tables, so if the investor outlives their average life expectancy, the annuity company makes a loss as they must keep paying the investor until their eventual demise. So if you have a family history of relatives living to 100, a lifetime annuity may be a wise option to consider. A 65-year-old male has a 21.6-year life expectancy. The table shows that the longer you live, the more you benefit from an annuity.
Following the changes to Centrelink rules in 2004 and 2007 that reduced, then removed the assets test exempt status of annuities, many predicted the annuity market would disappear entirely. However, with the onset of the global financial crisis in 2008, many shaken and battered investors changed their mind and have traded the opportunity for higher returns of shares and property, for the certainty and predictability of an income stream from an annuity.
Therein lie the main advantages of an annuity – the removal of investment risk, certainty of income and simplicity. By purchasing an annuity, the investor accepts a guaranteed return on their money for the term of the annuity. There is no worrying about going to the local bank branch to check out term deposit rates and no watching the 6pm finance news to see how their shares are performing.
The trade-off is that annuities generally restrict access to the capital invested, especially in the later years. The other disadvantage is that the interest rate paid on the money may be slightly lower than you could achieve elsewhere. This lower rate is to compensate the annuity provider for providing you with guaranteed income payments for sometimes very long periods.
An alternative to annuities is to use a super fund that employs a protection mechanism whereby the super balance does not decline when investment markets fall. By paying a protection fee of about 1 per cent a year on a balanced portfolio, the investor is able to build their super in the good years and ensure that the portfolio does not fall in the bad years. This type of product is especially attractive for those wanting the certainty of income, access to capital and increasing their super when sharemarkets rise.
As people today are living longer in retirement than ever before, the trend towards annuities and protected super accounts is likely to continue.
You should however seek financial advice before entering into these types of products as there are many factors to consider such as Centrelink, tax and estate planning.
James Gerrard is a financial adviser with PSK Financial Services in Sydney