For a nation that is broadly accepted to have the most developed and sophisticated pension system in the world, Australia has largely failed up until now to appropriately utilise one of the most valuable tools in a retiree’s arsenal, the humble annuity.
While lacking the sex appeal of direct equities and the familiarity of property, annuities can play an integral role in solving the funding issues faced by many retirees today. And with life expectancies only set to rise in the future, this is a problem that is only going to get bigger with time.
Now, while I am repeatedly told that the reason behind so few Australians buying annuities to fund retirement is because we are risk-tolerant, I am more inclined to believe that education is the issue, both at the investor and the adviser level. In this country, and I assume most others around the world, financial literacy is atrociously low, but that is a conversation for another time. What this article will aim to do, is breakdown a complex investment product (the annuity) into 12 easy to understand concepts to try and break through the knowledge gap.
Here are my top 12 insights into annuities and how to use them:
1. They are an insurance product at their core
The three biggest risks for retirees are; longevity, inflation and volatility. An annuity can deal with all three. One way to think about an annuity is that it is essentially like buying an insurance policy against you outliving your money, inflation rising and eating away at your real return and the sequence of returns increasing the rate that your capital is consumed.
2. APRA regulated
This is a really big thing which I will come back to again later when I talk about the risk. As these are insurance products, they are regulated by the Australian Prudential Regulation Authority (APRA). APRA is the regulator for the banks, insurance companies, superannuation funds, credit unions, building and friendly societies. This is critical as it allows APRA full and complete transparency into the capital adequacy of the provider of the annuities, the statutory fund that makes annuity payments, risk and capital frameworks as well and the overall business plan.
In some circumstances, if APRA is unhappy with the way a statutory fund is run, they can step in and take over.
3. They come in all different shapes and sizes
While the number of major providers of annuities in Australia is small, the number of different types of annuities is vast. You can choose your investment amount (subject to minimums). They can be fixed rate or CPI indexed. They can be 1 year or 50 year or one or both (couples) lifetimes. You can have all your capital returned at the end, or none of it or anything in between.
4. They can be used in a multitude of strategies
Because of all the different types of annuities, the opportunity for the use of annuities is vast. For example, annuities can be used to guarantee a portion of cash flow each year or they can be used to replace term deposits or low risk bonds to potentially increase returns without having to incur more risk.
Layering is a fairly underused strategy that is relatively conservative in nature. It typically involves breaking down your living expenses into needs and wants. Once you know how much cash flow you need to fund your needs, you go out and buy an annuity to guarantee this cash flow each year. The remainder of your portfolio you can allocate to higher risk assets like shares or property.
The end result is that you have the confidence that, year in year out, you can always meet your needs while being able to achieve your wants when markets go up. The critical value here is the reduction in the impact of sequencing risk.
6. Inflation hedging
Control is good, which is why it is always good to minimise things outside of your control that could hurt you. In the world of finance, inflation is one of those things. While Australia, like most places in the world today, is experience low levels of inflation, it won’t stay there forever. When life expectancies were shorter, and money only had to last four 5-10 years, inflation was not such a big deal. Now that 30 or 40 year retirements are commonplace, inflation is a really big deal. With CPI indexed annuities, not only can you guarantee cash flow, you can guarantee the buying power of that cash.
7. Forced discipline
One of the decisions to make on a fixed term annuity is what you want your Residual Capital Value (RCV) to be. In basic terms, RCV just means how much money is left at the end of the term. RCV 0 means nothing is left, RCV 50 means half is left and RCV 100 means the entire capital is left. By buying an RCV 0 annuity, it forces you to be disciplined with your spending so that you don’t run out of money early.
8. Where they sit on the risk spectrum
Just above a term deposit and just below a bond fund. These are very low risk investments. To put the risk level into perspective, all annuity providers fund their contractual payments out of what they call a statutory fund. The largest annuity provider in Australia’s statutory fund can withstand a 1 in just over 300 year event and still meet their payment obligations. For reference, the GFC was a 1 in 70 year event.
9. Improved aged pension outcomes
From 1 July 2019, there were substantial changes in the way lifetime income streams are assessed for Age Pension purposes. In essence, only 60% of the purchase price of a lifetime income stream is included in your assets test assessment until age 84 and then just 30% thereafter. This is a massive benefit to borderline pensioners who may now receive thousands of dollars extra per year or simply get the benefit of pensioner health care benefits.
10. Do I lose my money if I die?
Strangely enough, many people think that if you pass away before your annuity has reached maturity, you lose the capital left in the annuity. While this can be true for some lifetime annuities, it is not true for term annuities. If you pass away part way through a term, the remainder of the contract is added to the estate and inherited. Even for lifetime annuities there can be the option for reversion to be included to enable a surviving spouse or dependent to retain it.
11. Sequencing risk
Sequencing risk is the mismatch between a portfolio’s returns and the cash flow requirement of the investor. Generally, it has the greatest impact the day someone retires since that is normally when portfolio are largest. It is because of this that sequencing risk has to be one of the biggest considerations for portfolio construction.
An annuity, and the cash flow it guarantees, allows growth assets the time to grow without the need to sell in the short term when markets may be down. It is not possible to reliably predict when markets will rise or fall, the best you can do is limit the pain when they do fall.
12. Can be owned in super or out
Whether you are investing personal money, have an SMSF, retail or industry super, an annuity is available for purchase. They can be purchased directly with your own money with ease, just like they can in an SMSF. In addition, annuity providers will also accept super rollover money which ends up with them selling you what is effectively a pension product wrapped within a superannuation agreement.