With a rising number of Australians moving into retirement, the question on the minds of many is, “How can I be sure I will have enough to live on?”
A recent paper issued by Treasury, titled Retirement income covenant, pushes the option of guaranteed income streams, or annuities.
So, what is an annuity?
An annuity is a product that guarantees you a certain amount of income for a set period of time. There are two basic types: Term and lifetime.
The first guarantees you an income stream for a set period of life, and the second lasts for your whole life.
They are useful because they guarantee you won’t run out of money regardless of what happens.
Annuities and the pension
The government gives annuity holders improved access to the age pension to compensate for their money being tied up in an annuity and harder to access.
A superannuation balance is fully counted in the age pension assets and income tests. But annuities are discounted to 60 per cent of their value for both tests.
“So if you come in and buy a $100,000 annuity, it’s treated as $60,000 for the assets and income tests,” said Jeremy Cooper, retirement income chairman at annuity provider Challenger.
“You get a kicker, because as well as the annuity we’re paying, you’re actually getting more age pension.”
How do different annuities work?
Term annuities come in a variety of forms.
In their most simple, “they compete with term deposits,” Mr Cooper said.
That means you can use them to lock your money away for set terms and, in the current environment, earn a better return than the average bank offering.
Figures in the chart below are provided by Challenger and Canstar for a $100,0000 investment.
“Banks will typically give you up to five years, whereas we could go out for 10 years,” Mr Cooper said.
More complex term annuities also exist.
Some have a more market-based investment strategy and others keep all or some of your capital on expiry.
These types, which are often mixed in one, will pay you a higher annual return. That is because they compensate you for eating up your capital and have higher exposure to growth assets in the sharemarket.
Lifetime annuities offer a guaranteed income over the remainder of your life after you buy them.
Paramount Financial Solutions planner Wayne Leggett said their pricing is based on variables like “how old you are, how long you want the product to run, whether you are male or female, whether you want it indexed, and whether it is for you and your partner or just you”.
The table below demonstrates the workings of a Challenger lifetime annuity with $100,000 invested. The calculations are for a female, with a male receiving slightly higher payments because they are expected to die two years earlier.
An annuity is in some ways a kind of gamble with life expectancy. If you outlive the withdrawal period, it is likely that you will earn more than you put in.
However, if you die earlier than the withdrawal period, which is calculated from your age at joining and your life expectancy, then the annuity group wins. And your heirs will receive some residual payments until your withdrawal age.
Remember the amount you are paid out is not simply the amount invested divided by the withdrawal period. That’s because your capital declines over time because of the yearly payouts you receive.
Who are they good for?
If you haven’t got much money, you are better off selling your assets and receiving a part pension.
Research provided by the Australian Institute of Superannuation Trustees shows that people with less than $250,000 in retirement savings would be better off on a superannuation pension using the age pension as their longevity insurance.
But it’s not all or nothing.
Mr Cooper said annuities can work for people with relatively modest super savings in a partial way.
“Say if you have $300,000, you might say, ‘Well, keep $200,000 in your super account and put $100,000 in an annuity’,” he said.
“That way, if the sharemarket blows up or you overspend a bit you’re always going to have the annuity payment to rely on.”
Mr Cooper said annuities work better for people with middle-range retirement balances than the rich or those with little savings.
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