Retirement planning – the ins and outs of an annuity
An annuity is a little known income option for retirees that can provide some certainty in an uncertain world. Here’s how they work:
What is an annuity?
The concept of an annuity is fairly simple. You provide a lump sum of money and, in return, the annuity provider promises to pay you a series of payments over a set timeframe. In other words, you are swapping your lump sum of money for an income stream. This can assist to fund your retirement and replace the regular pay cheque you once received from work.
Fixed term vs lifetime annuities
There are two main types of annuities you can choose from. A fixed term annuity, as the name suggests, continues for a specific term e.g. you invest in a 15-year annuity; the payments are guaranteed to continue for 15 years.
A lifetime annuity works a little differently. Here the payments will continue or last as long as you do – continue to be paid during your lifetime. So, if you have strong genes in your family and are in good health, a lifetime annuity is an appealing option. These days, lifetime annuities often come with the option of a ‘guaranteed’ period, meaning even if you were to succumb to a premature death, the balance of the annuity could be paid to your estate. To a degree this allows you to hedge your bets, though it will likely compromise your return somewhat.
Can you use your super to invest in an annuity?
You can use your accumulated super to invest in an annuity. By doing so, you receive the same generous super tax concessions, which mean your income payments are tax-free and non-assessable, once you reach the age of 60. Ordinary money e.g. money in a bank account, can also be used to invest in an annuity, though different tax rules will apply.
How does an annuity differ from more traditional income streams, such as an account-based pension?
Annuities provide certainty. Regular payments are guaranteed over a set time frame, depending on the option you choose. This certainty means you compromise on a couple of things though. Once you set up an annuity it is, more or less, set in stone. You can’t vary the payments, nor can you withdraw a partial lump sum from the annuity.
Account-based pensions on the other hand, do offer flexibility to vary payments at any time and withdraw a partial lump sum, should the need arise. This flexibility is one of the reasons that retirees often opt for account-based pensions for the bulk of their retirement savings.
Finally, one of the biggest differences is that the returns from an annuity are not market-linked. The funds within an annuity are generally income guaranteed, and not at the mercy of the stock market. This provides more security, though removes the opportunity for capital growth on your funds.
How does Centrelink assess an annuity?
Annuities have special treatment when it comes to Centrelink. Centrelink combine the total amount of your annuity payments for the year and then subtract a ‘deductible amount’ to work out how much income they count. It may sound like a large amount, but in many cases the reality is that it ends up being very little income (if any) that is assessed. The ‘deductible amount’ exists to allow for the fact that part of the income you receive each year, is actually a return of capital of your own money.
What investment return can you expect from an annuity?
With an annuity, you will know the investment return for the life of the annuity, from the outset. This does not change. A quote should be prepared, generally with the help of a financial adviser, which will spell out all the particulars of the annuity, including the earning rate.
There are many variables that can influence the earning rate, including things such as the type and term of the annuity, along with what different options are selected. As a rough guide, it’s not uncommon for annuity returns to be similar to what you would get on a one or two year term deposit with a bank. Though as stated, this return is highly dependent on the different options selected, not to mention the prevailing market interest rates at the time. So the first step would be to get a quote prepared for an indication of the earning rate.
An annuity can be a viable option for part of your retirement nest egg. They offer some certainty in your cash flow for retirement, without the ups and downs of the share market. As always, you should get some advice beforehand, so that you are clear on what’s involved and whether it’s right for you.
Wally David, CFP®
Financial Planning Matters