What are annuities?
An annuity is a simple, secure financial product that guarantees a series of payments in return for an upfront investment. The capital can be returned at the end of the agreed term or gradually during the term of the annuity.
The rate of return is fixed at the outset, regardless of share market movements or interest rate fluctuations. Annuities provide the comfort of knowing you will receive a pre-agreed, guaranteed income stream for a specific period of time.
Annuities can only be issued by life insurance companies. In Australia they are strictly regulated by the Australian Prudential Regulation Authority (APRA).
Benefits of annuities
The beauty of annuities is that everything is ‘locked in’ at the start of the investment. You know what to expect every month or every year for the life of your investment. Other benefits include:
Security – your interest and capital payments can be guaranteed, regardless of how the share market and how other investment markets perform.
No product fees – there are no management or account keeping fees. The rate of return and the amount of income to be paid each period are agreed upfront and there are no fees to be taken out of these amounts.
Flexibility – you can choose the term of the annuity, the frequency in which you receive payments or whether you receive your capital back in a lump sum at the end or over the course of the annuity.
Ability to remove inflation risk – you can also elect to index your payments so they move in line with inflation (CPI) or fixed indexation.
Tax effectiveness – if bought with superannuation monies, and if minimum payment requirements are met, income from annuities will be tax free for investors over the age of 60.
Lifetime income – in the case of a lifetime annuity you can enjoy a guaranteed regular income for your lifetime.
Attractive rate of return – annuities offer highly competitive earning rates compared to many other fixed income investments.
Features of annuities
Annuities are a relatively simple product; you make an initial investment and receive regular income payments over time. However some unique terms are used to describe certain features of annuities that do not apply to other investments.
Term
‘Term’ refers to the length of an annuity policy. Fixed term annuities are generally available for fixed terms of between one and 50 years. The investor selects the term most appropriate to them. The term of a lifetime annuity is the rest of the policy holder’s life – income payments continue until the policy holder dies.
Earnings rate
The earnings rate (or rate) refers to the interest paid by a fixed term annuity. For example, an investor taking out a $100,000 three year annuity, which was paying a rate of 6.5% with annual income payments, would receive interest of $6,500 each year. The rate provided at the time of the investment applies for the term of the annuity.
Income payments
Income payments can generally be made monthly, quarterly, half-yearly or annually. The amount of income paid can be fixed at the outset, indexed by a set percentage or indexed to inflation. Indexing against the impact of inflation may be particularly relevant for long-term annuities as it provides protection against cost of living increases.
Residual Capital Value
Any capital left at the end of an annuity term is known as ‘residual capital value’. The residual capital value, or RCV, is set by the investor at the start of the annuity. It can be 100% of the capital invested, 0% of the capital, or somewhere in between.
In the case of a 100% RCV annuity (also known as RCV100), income payments are made up entirely of interest earned on the investment. The initial investment amount is preserved and paid back to the investor when the policy ends.
At the other end of the spectrum, income payments for a 0% RCV annuity (also known as RCV0) include interest earned on the investment and a portion of the original capital invested. There is no capital left at the end of the investment.
The RCV can generally be set at any level between 0 and 100. If an RCV of 50 is set, then 50% of the initial capital is paid out through income payments and 50% is repaid to the investor at the end of the term.
Which features are best for you?
Should you decide to invest in an annuity, your circumstances and income requirements will determine how to construct your annuity investment. A financial adviser can help you choose the best terms, payment frequency and RCV for you.
Types of annuities
Fixed term annuities
Fixed term annuities have a fixed start date and end date as chosen by the investor. The term can be as short as one year or as long as 50 years. Income payments are made for the duration of the term.
Lifetime annuities
Lifetime annuities are designed to pay an income for the rest of an investor’s life. Income payments start when the investment begins and end when the investor dies.
With each generation generally living longer than the last, there’s every chance you will outlive your savings. In fact, our research shows that for a 65 year old couple there is a 50% chance that at least one partner will live to 98 years of age.
Lifetime annuities can help alleviate the worry that you will outlive your retirement savings by paying you an income until your death.
Complying annuities
A third lesser used, type of annuity is a complying annuity. Complying annuities are either 50% or 100% exempt from the assets test for social security purposes. A small number of investors purchasing an annuity with superannuation monies rolled over from a self-managed super fund that is currently paying an Assets Test Exempt (complying) income stream may be eligible for a complying annuity. If you think you may qualify for a complying annuity we recommend you speak to your financial adviser.
