What are annuities, and how can they help in retirement?

Impact of the Retirement Income Covenant

With retirees increasingly concerned about longevity risk and seeking pension products that address these concerns, products like annuities are receiving fresh attention.

Interest is also being boosted due to the government’s new requirement for super funds to consider the needs and preferences of members who are retired or approaching retirement to ensure they have greater choice in how they withdraw their super benefits in retirement.

From 1 July 2022, trustees of APRA-regulated super funds are required to have in place a Retirement Income Covenant providing a strategy to assist members achieve and balance three retirement objectives:

• Maximise their expected retirement income
• Manage the expected risks to the sustainability and stability of this retirement income
• Have flexible access to expected funds during retirement.

How do annuities work?

Annuities are divided into two main types:

1. Lifetime annuity

You receive a regular payment for your entire life, regardless of how long you live. This can be appealing if you are in good health and your family tends to live a long time.

Most lifetime annuities also offer the option to choose a guaranteed period. This means if you die during the guarantee period, the balance of your annuity is paid to your estate.

2. Term certain (or fixed term) annuity

With this type of annuity, you receive a regular payment for a specific term or time period.

Term certain annuities are usually available for a period from 10 to 25 years and are guaranteed to continue paying you for the term you select.

Some life companies also offer a deferred annuity. These products allow you to buy the annuity product but not receive your payments until after an agreed deferral period.

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Annuities and your super savings

You can buy an annuity with either your super savings or non-super money (such as the proceeds from an inheritance or property sale).

If you use your super savings to buy an annuity, you receive the same tax concessions as you do within the super system. This means once you reach age 60, your income payments are tax free and not assessable for tax purposes.

What happens to my annuity if I die?

When you take out an annuity, generally you have a choice about what happens to your annuity on your death. You can select:

1. Reversionary beneficiary

Your nominated beneficiary receives your income payments until their death, although this is usually at a reduced level (such as 60%).

If the annuity was purchased with super money, the reversionary beneficiary must be a dependent person under super law.

2. Guaranteed period

Your nominated beneficiary receives your payments (either as a lump sum or an income stream) for a set period you select when you buy the annuity.

Unlike the reversionary beneficiary option, the income payments received under a guaranteed period are not reduced and are only paid for the guaranteed period.

If you are in a relationship, you are free to purchase your annuity either in your own name or jointly with your partner.

Buying your annuity in a joint name with your partner means you can split the income, which may have tax benefits.

With a joint annuity, when one partner dies the survivor becomes the owner of the annuity and has access to the money either as an income stream or a lump sum.

Benefits and drawbacks of annuities

Benefits

• Guaranteed income regardless of moves in investments markets
• Income for the rest of your life (if you choose a lifetime option), regardless of how long you live
• Returns are based on average life expectancies, so if you live longer than the average person, you’ll receive more in total payments
• From age 60, annuities purchased using super money are tax free
• Investment earnings are tax free
• Annuities can be used to supplement other retirement income streams (such as account-based pensions)
• Income payments can be indexed to increase each year to combat the impact of inflation
• Provides a known cash flow to cover essential expenses so you can feel more comfortable with discretionary spending decisions
• May provide an increase in your Age Pension entitlement

Drawbacks

• You may be able to achieve higher returns outside an annuity, although this may involve more risk
• No control over how the money is invested, which could be an issue for responsible/ethical investors
• It may not be possible to transfer your money out of the annuity contract
• After your death, any money left may not be payable to your dependents or family
• With a long-term annuity, your purchasing power is reduced over time due to the impact of inflation
• You may lose a percentage of your money if you cancel the annuity or withdraw your money before the end of its term
• Less flexible than an account-based pension

Income from your annuity

The income you receive from an annuity is set when you buy the annuity and does not change over time. Your payments can be received monthly, quarterly, every six months or annually – the decision is up to you.

When you purchase an annuity, you can choose to protect your income payments against inflation by paying an additional fee to have the payments indexed each year, either by a fixed percentage or in line with inflation.

Your actual income payment depends on a number of factors, such as how much money you are prepared to pay towards the annuity and the rate the annuity provider is currently offering.

The payment amount you are offered by your annuity provider is based on complex actuarial calculations covering things like your predicted lifespan, the options you have selected and the outlook for investment market returns.

The rates offered by annuity providers vary over time, so it’s important to check how the current rates compare with other investment options for your money.

How does an annuity differ from an account-based pension?

An account-based (or allocated) pension provides you with a regular income stream from your super savings in retirement. To invest in an account-based pension, you must have reached your preservation age or met a condition of release for your super.

With an account-based pension, your savings are invested in a range of asset classes (such as shares and bonds) you select when you start your income stream. It’s important to remember that although this provides potential for growth and higher investment returns, it also adds risk and your savings may run out before you die.

Annuities, on the other hand, are not affected by the performance of investment markets. You are guaranteed to receive set regular payments throughout the life of your annuity.

Account-based pensions also offer the flexibility to vary your payments at any time (provided they meet the required annual minimum pension withdrawal rate set by the government) and to make lump sum withdrawals. Annuities don’t offer this flexibility, which is why many retirees select account-based pensions for the majority of their retirement savings.

Annuities and the Age Pension

Eligibility for the Age Pension is determined by both your age and an assessment under the Age Pension income and assets tests.

The account balance of an annuity is considered an asset for the Age Pension assets test, while payments from the annuity are assessed under the Age Pension income test.

From 1 July 2019, the rules for assessing the purchase of a lifetime annuity (not a term annuity) under the Age Pension tests were changed. For all lifetime annuities commencing after that date, only 60% of the capital invested in a lifetime annuity is assessed for a set period. Previously, the entire account balance and gross income (less any return of capital to you) were assessed.

The bottom line

For some retirees, annuities can be a valuable strategy to consider when developing your retirement income plan.

They provide a source of diversification for your retirement income, while also minimising the risk of outliving your savings and having insufficient income to fund your life after work.

Although they have many benefits, annuities are not appropriate in every situation, so it’s important to seek professional advice about their suitability for your particular financial circumstances and goals before you purchase one.