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Lifetime annuities making a comeback
Challenger Financial Group (ASX: CGF) reported $842 million in Australian equity sales in the first quarter of the 2020-21 financial year, this represented 35 per cent growth on 2019 levels. The standout though, was a doubling in lifetime annuity sales to $208 million as investors returned to an asset class that was last popular in the early 2000’s.
The Latin word annua meant the payment of ‘annual stipends’ with most experts dating the concept back to the Roman Empire. The original concept remains intact, involving a single large payment from a person being converted into an annual payment made each year until their death.
Much has changed in the many decades since, with the annuity sector now highly regulated and an increasingly attractive option for retired investors. In 2020, annuities are typically split into two types: immediate or term annuities and lifetime annuities. Both of which are likely self-explanatory.
Immediate term annuities act similar to a term deposit, offering a guaranteed level of income for an agreed term, be that 2, 5 or 10 years. Importantly, all capital is generally returned under this option. The alternative is a lifetime annuity, through which the investor is entitled to an annual payment for the remainder of their life. In this case, their capital will not be returned in full at the end of their term.
Ultimately, annuities are like loans to the annuity provider. You are providing them with capital, which they then invest and seek to generate, through professional management, a consistent return. The risk of underperformance then lies with the annuity provider, who must generate sufficient returns to fund the agreed income payments. The risk of the investor is effectively limited to the solvency of the annuity provider. It is for this reason that annuity providers are treated like insurance companies and face capital requirements via the Australian Prudential Regulatory Authority.
The main reason investors utilise annuities, is to reduce the risk of outliving their retirement savings, achieved by locking in a guaranteed income for a set period of time. In recent years, the guaranteed income has fallen alongside interest rates, meaning people need to investor more capital for the same amount of income.
Another key benefit is the ability to link your income payments to either inflation or more recently the RBA Cash Rate, which means you will not be in a worse position if inflation does occur during your retirement. Importantly, annuities remove the impact of market volatility and risk from your investment decisions.
One of the primary drawbacks is the return on offer from these products, which are generally above term deposit rates, but below higher risk alternatively. As annuities are defined benefit products, annuity companies tend to focus on delivering consistent returns without taking significant amounts of risk, reflected in the rates on offer.
One of the more common uses of annuities in Australia is to increase Age Pension entitlements as they receive special treatment under the Centrelink Age Pension means tests. For approved lifetime annuities purchased after 1 July 2019, only 60 per cent of income payments are assessed under the income test and 60 per cent of the purchase price of the annuity up to 84 years of age and 30 per cent thereafter. This can clearly be valuable for those nearing the Age Pension cut offs.
