The ins and outs of annuities

An annuity is a financial contract, usually in the form of an insurance policy, where the seller makes a series of future payments to the buyer (“annuitant”) in exchange for the immediate payment of a lump sum up front, or a series of regular payments, prior to the commencement of the annuity payment stream.

Fixed term annuities have a specified term e.g. 1 – 30 years and, in many ways, are similar to an investment in a bond or term deposit.

Alternatively, lifetime annuities have payments over the life of the annuitant, with income starting when the investment begins and ends when the annuitant dies. With fixed term annuities, the annuitant assumes their own longevity risk (i.e. the risk that they live longer than expected), whereas with the lifetime annuity, that risk is shifted to the insurer.

Fixed term annuities can be tailored by both the term of the annuity and the residual capital value. The residual capital value, or RCV, is set by the investor at the start of the annuity. It can be 100% of the capital invested, 0% of the capital, or somewhere in between. Where the RCV is less than 100%, the regular payments to the annuitant will comprise of a blend of income and return of capital over the term of the annuity.

Rates of return – guaranteed or market-linked

Annuities can have either a fixed, guaranteed rate of return e.g. 6% per annum or they can have a variable or market-linked return, which may be linked to the performance of a market index or investment fund. Annuities can also have an inflation-linked return so that annuity payments are increased by the rate of inflation.

As annuities are primarily used to generate income in retirement, they can be compared to other retirement income strategies such as bank deposits, allocated pension products or other income-generating investment strategies.

Customer benefits

The benefit of annuities can include:

• higher earnings rates than many other fixed income alternatives, such as bank deposits and government bonds, as annuities are issued by insurance companies which tend to have lower credit ratings and therefore offer higher yields

• guaranteed returns for very long terms (i.e. 30 years or more) which are generally not available from banks and bonds in the Australian market

• elimination of the risk of outliving your savings using lifetime annuities as the insurance company assumes your longevity risk

• market or inflation-linked income streams to provide capital growth or inflation protection that may not be explicitly provided in other retirement income products

• no management fees as fees are incorporated into the annuity rates offered

• relatively simple and flexible

• income can be tax-free in Australia if the annuity is purchased with superannuation money and the minimum income payment requirements are met.

Because annuitants have credit risk on the insurer i.e. they take on the risk of the insurer or annuity provider becoming insolvent and stopping annuity payments, investors taking out annuities need to ensure the annuity provider is well-rated by ratings agencies and is regulated. In Australia, life insurers are regulated by the Australian Prudential Regulation Authority, which ensures that the insurers are well capitalised and hold sufficient liquid assets to meet expected annuity and death benefit pay-outs.