A Brief Introduction to Annuities
Annuities are simply a product where, in exchange for your paying a lump sum, you become entitled to receive a guaranteed income for a defined period of time. It sounds simple - you are in effect buying yourself a private pension - but in practice annuities can be relatively complicated products.
Currently, in our system, super fund members effectively bear both the investment risk and longevity risk during their retirement period, and this poses real challenges for retirees trying to translate a lump sum into a reasonable income for the remainder of their life. In essence, how does a retiree know how to plan properly if they don't know precisely how long they are going to live?
The use of "lifetime" annuities could resolve this dilemma, but annuities have not proven popular in Australia compared to other countries such as the US and UK, despite the fact that they are a very good fit for retirement income. Some of the reasons are complex and technical in nature, others come down to whether they provide a competitive income and their relative complexity and inflexibility.
We concentrate on exploring these latter two issues, to provide some background in advance of a discussion with your financial advisor - who should certainly be involved in this type of decision.
Complexity and Flexibility
In essence, as we mention, annuities appear a simple product. In practice, however, there are many types of annuities in the market and when you are considering a purchase you need to be very aware of the different product conditions and options. Purchasing an annuity is a significant decision that may have major implications for the remainder of your retirement. The flipside of having a product that guarantees you an income, regardless of how the economy or markets may perform, is that you will probably be locked into the product and unable to withdraw any funds early, regardless of how your circumstances may change.
We have summarised some of the different annuity options below:
- Fixed "Term" or Lifetime Annuities - you can choose to buy an annuity which is for a fixed period of years (e.g. from 1 to 50 years) or one that provides for a regular payment until you die.
- Payment Frequency - you can choose how often you receive payments, such as monthly, quarterly, six monthly or annually. The higher the frequency of payment the less you will receive on a comparative basis - simply because the provider is able to retain the funds longer and hence earnings, and because more frequent payments mean higher administration costs.
- Withdrawal and Access to Capital - annuity products are typically designed to be held to "full term", but some products will provide an option to access all or part of your capital early. There will however be a direct or indirect cost attached - for example the capital available will probably be less than that available at "full term". It will usually be possible to specify a period within which, if you die and have not elected a reversionary" (see below), then the annuity provider will pay your estate an agreed withdrawal value.
- Indexation or Inflation proofing - you can typically choose to have the regular payments fully or partially adjusted in line with the Consumer Price Index (CPI) or not at all. Providing for inflation can significantly affect the cost of the annuity or the value of initial payments.
- Reversionary or not - you can nominate someone else to receive your payments in the event of your death - they are known as the "reversionary". If the annuity is being purchased with super funds then the reversionary must be your spouse. Logically, the additional cost will depend on the life expectancy of the reversionary. Note that if the reversionary dies before you then typically you cannot elect another person as a reversionary, although you can cancel an election. You can often reduce the payment to any reversionary, which will often make sense with a married couple where expenses will decline and you wish to maximise payments prior to death. Married couples should also consider whether an annuity should be held on a joint owner basis, and whether benefit reductions should apply, and to what extent.
Are Annuities competitive enough?
There is little doubt that annuities should play a larger role than they currently do in providing retirement incomes, probably in concert with their major rival, account based pensions. The reasons they currently don't feature as significantly as they should, can be summarised as follows:
- In exchange for income stability, you forego potential benefits if the sharemarket or interest rates increase substantially.
- The investment returns which are included in current annuity rates invariably reflect (historically low) interest rates - well below the long term returns that might be expected from a balanced portfolio
- Much can change over 20 to 30 years, and many individuals are concerned at being locked into products which are perceived as being inflexible, and
- Australia is relatively poorly served when it comes to annuity providers, with only three current providers and the market would benefit from more competition.
In principle, and assuming competitive annuity products, you could very well see retirement income portfolios comprising both annuities, covering base income requirements, and account based pensions including growth investments which provide a hedge against inflation over a period of 20 or 30 years.
It's worth noting at this stage that annuity products are almost universally described as "guaranteed". However, that guarantee is only as good as the underlying annuity provider. Australian regulators such as APRA have an excellent reputation, but nonetheless there is a (very) small risk that needs to be appreciated in any assessment of this product. This is particularly the case if annuity providers take additional risks in order to chase higher yields in a world where fixed interest returns seem to be trending to zero.
The tax treatment of annuities depends on the age at which they are purchased and the source of funds, in particular whether they are purchased from superannuation funds or otherwise:
- Annuities purchased with super money are tax free from age 60
- Annuities purchased with super money prior to age 60 will have the taxable portion taxed at your marginal tax rate, but you will receive a 15% tax offset.
- Only the income component of an annuity purchased with non-super money is taxable, not any return of capital
Asset and Income Test Treatment for Age Pension Purposes
The manner in which annuities are treated for both the income and assets test can be complicated, depending on a number of factors; including whether you are considering term or lifetime annuities and whether there is any reversionary beneficiary. A number of historical products are also subject to special treatment - "grandfathering".
Importantly, however, new means test rules for lifetime annuities come into effect from July 1, 2019. For qualifying products, these rules will see the income test include only 60% of all income and the assets test include only 60% of the nominal purchase price as an asset until the individual reaches the life expectancy of a 65 year old male (currently age 84) - or a minimum of five years - and then 30% of the purchase price for the rest of the individual’s life.
These new rules should now make lifetime annuities a more attractive product - particularly for individuals who currently qualify for only a partial aged pension, or just fail to qualify for a pension - with 40% of any purchase price immediately exempt from the assets test. Depending on your circumstances, and the attractiveness of the annuity, this may provide a much better way of qualifying for an aged pension than, for example, choosing to renovate the family home or simply spending on discretionary purchases or experiences.
We recommend that anyone considering the purchase of a retirement annuity first obtain professional advice, but it is going to be advantageous if clients first obtain a general working knowledge of annuities and that is the focus of this short introductory document available for download.