Annuities are a product most people have heard of, but don’t know exactly what they are, or when to use them. With interest rates returning to more normal levels, annuities are coming out of the deep freeze. So this week I thought I’d take you through the basics of annuities so you have an appreciation for where they might have a use in your financial plan.
Let’s kick off with a definition. An annuity is a fixed contract product that produces income. The easiest way to think about them I find, is as a term deposit with extra functionality.
At its simplest, you might for instance take out a three-year annuity with a fixed interest rate of 5%. Typically that annuity would pay you income every month, and at the end of your three years you get your money back. Their attraction derives from their certainty. You know what you’re going to earn, you know when you’re going to be paid, and you know the value at the maturity date.
But annuities can be far more varied than this straightforward example. You can structure them so that at maturity they are worth something less than what you put in. In this way part of your capital, or perhaps even all of your capital, is progressively drip fed out to you with each income payment.
So let’s say you had $100,000 and you wanted to use $10,000 of that each year for ten years, plus the interest. You could establish a 10 year annuity where the maturity value is zero. Every month you would receive a payment into your bank account representing the interest on your money plus some of your own capital returned to you. You have a guaranteed and predictable amount of income, with no risk of going through it too quickly.
You could structure an annuity to start with $200,000 and in 10 years mature with a value of $100,000. Again this protects you from going through your money too quickly, and provides you with regular, predictable income.
Annuities can have inflation adjustments built into them. You could have an annuity where the amount of income you receive is adjusted every year in accordance with inflation. That feature has been very handy over the last year or two.
You can also get lifetime annuities. These are annuities where you receive a payment each month for as long as you live. They have certain guarantees so that if you pass away in the early years of the annuity, the balance gets paid out to your estate. But the attraction with lifetime annuities is that there is no prospect of you out-living your money. Payments just continue for as long as you’re above the ground. You would typically want inflation adjustment on these type of policies given they will hopefully run for a very long time. Lifetime annuities can be thought of as a type of insurance. Great for peace of mind.
Okay, so hopefully you’ve got a sense that annuities provide certainty with a high level of flexibility around their structuring. Let’s now explore use cases.
Let’s say your risk profile is growth. That would typically mean that 80% of your savings are in investments like shares and property, where the expectation is they will increase in value over time. The remaining 20% of your savings though is intended to be in low risk, conservative investments. Typically the bulk of this will be bonds. One use case for annuities is to replace some or all of the bond portion of the portfolio with fixed annuities instead. In recent years bonds have suffered capital losses as interest rates have risen. This is a somewhat unexpected outcome for the portion of the portfolio that is supposed to be low risk. Using annuities instead of bonds removes this potential for capital loss.
In this scenario we might use a three or five year annuity and roll that over at maturity.
Because of the high level of certainty associated with annuities they can be useful in enabling you to be more aggressive with your other investments. Imagine you are retired and you need an income of at least $50,000 per year. We could put $250,000 into a 5 year annuity with a zero dollar maturity value. Such an annuity would pay you out your $50,000 each year, via monthly payments, plus the interest on your money.
With your income needs certain and guaranteed, you could then invest the remainder of your retirement savings in 100% growth assets, with the confidence that even if markets took a dip, you would have no reason to sell, and can therefore wait for the inevitable recovery.
As this example points to, annuities usually have an application when you require income, and therefore are a discussion item at the point of retirement, or perhaps after retirement. It would be very unlikely that 100% of your retirement savings went into an annuity. As much as they give you certainty, they lack flexibility. Once you put the money in, if your plans changed and you needed to get it out, there would either be harsh financial penalties involved, or it may simply be impossible.
As such typically we use annuities for 10-20% of a retiree’s total superannuation savings. And I should say that it doesn’t need to be superannuation money to go into an annuity, any money can go into an annuity, but superannuation funds are the most typical.
Annuities can have some Centrelink assessment benefits, particularly where you have a lifetime version. Centerlink will progressively reduce their assessed value of your annuity to roughly approximate its current value. As the assessed value reduces your age pension entitlement tends to increase.
Annuities are also often used when people enter aged care. This is a specialist area that we don’t operate in so it’s not one I can expand on greatly, but certainly if this is an area that you get into, perhaps for your parents, it’s quite likely that annuities will be something that comes up within the planning, so its helpful to have a basic understanding of what they are.
As mentioned in my introduction, annuities have been off the agenda for a long time because of very low interest rates. When you’re talking about locking money up for 5 years, 10 years, or maybe your lifetime, you want to be doing that in a time of attractive interest rates. With rates now back in the 5% range, the certainty provided by annuities means that they should certainly be considered for anyone implementing a retirement income plan. To have a portion of your retirement savings fixed and producing a guaranteed level of income is very helpful in your retirement planning, and in minimising the risk of you outliving your savings.
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