What are Annuities and what role do they play in Retirement?

Most people are familiar with annuities, but they don’t really know what they are or how to use them. Annuities are emerging from the deep freeze as interest rates return to normal levels. This week, I thought it would be a good idea to take you through some of the basic annuities in order to give you a better understanding of their potential use within your financial plan.

Let’s start with a brief definition. An annuity product is a contract that provides income. They are best thought of as term deposits with added functionality.

You could, for example, take out a 3-year annuity at a fixed rate of interest of 5%. An annuity is a contract that pays you a monthly income. At the end of three years, you will get your money back. The certainty of annuities is what makes them so attractive. You know exactly what you will earn when you are going to get paid and the value of the bond at maturity.

Annuities are much more complex than this simple example. You can design them so they will be worth less at maturity than you invested. This allows you to slowly drip-feed your capital or even your entire capital with each income payment.

Let’s say that you have $100,000, and you want to spend $10,000 each year plus interest for ten years. You can create a 10-year annuity with a zero maturity value. You would receive monthly payments into your account that represented the interest earned on your money plus a portion of your capital. You get a predictable and guaranteed income without the risk of it being spent too quickly.

An annuity could be structured, to begin with $200,000 and mature in 10 years with a value of $100,000. This protects your money from being spent too quickly and gives you a regular income.

Annuities can be designed to include inflation adjustments. An annuity could be set up where your income is adjusted annually to account for inflation. This feature has proven to be very useful over the past year or so.

Lifetime annuities are also available. You can get lifetime annuities, which pay you a monthly payment for the rest of your life. The annuities have guarantees that ensure the payment of your balance if you die in the first year. The main attraction of lifetime annuities, however, is the fact that you will never outlive your money. The payments continue as long as the person is above ground. These policies are likely to last a long time, so you’ll want them to be adjusted for inflation. Annuities for life can be considered a form of insurance. Peace of mind is a great benefit.

You’ve probably gotten the idea that annuities offer a lot of flexibility in structuring and a great deal of certainty. Now, let’s explore some use cases.

Say your risk profile is one of growth. This would mean that you’d invest 80% of your money in shares or property where it is expected to increase in value. The rest of your savings are intended to be invested in conservative, low-risk investments. The majority of your savings will likely be in bonds. Annuities can be used to replace all or part of the bonds in a portfolio. Bonds have experienced capital losses in recent years as interest rates rose. This is an unexpected result for a portion of the portfolio that is supposed to have low risk. Annuities are a better alternative to bonds because they eliminate the risk of capital loss.

In this case, we could use an annuity of three or five years and roll it over at maturity.

Annuities can help you invest more aggressively because of their high level of security. Imagine that you’re retired and need a minimum of $50,000 in income per year. We could invest $250,000 in a 5-year annuity that has a zero-dollar maturity value. An annuity of this type would pay out $50,000 per year in monthly payments plus interest.

You can invest your remaining retirement savings into 100% growth assets. This way, even if the markets dip, there is no need to sell, and you can wait for the inevitable market recovery.

Annuities are usually used when income is needed. This means that they can be discussed at retirement or even after retirement. An annuity would not be the best option for your retirement savings. They are not flexible despite the fact that they provide certainty. If your plans change and you need to withdraw the money, you will either face harsh financial penalties or it might be impossible.

Annuities are typically used for 10-20% of a retiree’s total superannuation. It doesn’t have to be superannuation to buy an annuity. Any money can do it, but superannuation is the most common.

Centrelink can provide some assessment benefits for annuities, especially if you own a lifetime option. Centrelink will gradually reduce the assessed value of your annuity until it approximates its current value. Your age pension entitlement increases as the assessed value decreases.

Annuities are often used by people who enter aged care. It’s a specialist field that we do not operate in, so I cannot elaborate on it much. However, if you are planning for your parents or another family member, annuities may be a topic that is discussed.

Annuities, as I mentioned in my intro, have been out of fashion for many years due to very low-interest rates. If you are planning to lock money away for five years, ten years, or even your entire life, then you should do so at a time when interest rates are attractive. Annuities are a great option for those who want to implement a retirement income strategy. With interest rates back at 5%, they offer reassurance. It is important to plan for retirement and minimize the risk that you will outlive your savings by having a fixed portion of your retirement funds.