Do Higher Rates Make Annuities a Retirement Option?

Planning for retirement is planning to manage a series of risks as best you can. These include:

• The risk of volatile market returns
• The risk of living longer than our portfolio can support (longevity risk)
• The risk of inflation
• The risk of changes in retirement rules (legislative risk)
• The risk of an unusually low period of cash rates (as we saw recently with the 0.1% RBA rate)

There does not yet seem to be the perfect retirement product that helps manage all these risks in the one place so perhaps our job as investors, to some extent, is to put together a number of solutions that manage as many risks as possible as best we can, while taking into account our own individual situations.

To be fair, the historical return from investing in Australian shares, with a focus on dividends, has been pretty close to an investment nirvana that helps cope with volatility, longevity, inflation and low interest rates. The ability to put together a portfolio of Australian shares with a 4 per cent-plus yield, an extra 1.5 per cent effective income in the form of rebated franking credits and spend the fully-franked dividends while leaving the capital untouched is an unquestionably attractive arrangement. But is it prudent to rely on one geographical market, albeit our home market, to do the heaving lifting going into the future?

Cash Rates and Annuities

Annuities are a retirement alternative that can be overlooked as an option during times of low cash rates – such as the extended period we have just come through. The return from an annuity is generally tied to the underlying cash rate, so the lower the rate the less attractive annuities tend to be.

As interest rates become more attractive the return offered by annuities becomes more attractive, and with the current RBA target cash rate of 4.1 per cent pa, that return is considerably more attractive than it was 15 months ago.

Let’s quickly start with a basic definition of an annuity – it is a regular income stream in exchange for a lump sum investment. The annuity might be started using money in a superannuation fund or money saved outside of superannuation.

Annuities as a personal finance solution including the range of options, as well as some of the issues (including how annuities interact with Centrelink and estate planning), could fill chapters of a book – this article can only be a very brief reminder of what they offer.

While there are an increasing variety of annuities that can be taken out, I want to focus on two particular characteristics that I think make an annuity an interesting addition in the mix of retirement solutions that can be used by investors: specifically, an annuity with a lifetime term; and an inflation-linked or CPI-indexed series of payments.

A lifetime term means that you will be paid a regular income stream in exchange for your initial capital until your death. An inflation-linked or CPI indexed payment stream will see this income adjusted for inflation.

In the possible mix of retirement solutions, these two features, the first of which protects against longevity risk (outliving your investments) and the second which protects against inflation, are worth being aware of.

Indeed, you might wonder why you don’t put all of your money into an annuity? The answer is likely to be that the underlying rate of return is generally still based on the cash rate, which is likely to be less than the return from growth assets over the long-term, and because you have to give away your capital (although some capital might be refundable if you stop the annuity during the term).

Annuities and Age Pension Rules

It is also worth noting that annuities may allow a retiree better access to the age pension. This is because an annuity that meets certain requirements only counts at 60 per cent of its value for the age pension asset test (See this link for more: Income streams - Age Pension - Services Australia).

This might be of particular interest to people planning retirement who are eligible for a part age pension, or who have assets just above the asset test threshold. Given the steep ‘taper-rate’ of the current asset test, a modest reduction in assets by using an annuity might result in an attractive increase in the amount of age pension received.

The tax-treatment of income from an annuity can be different depending on whether it is purchased with superannuation money or non-superannuation money, something worth being aware of for planning.

An Example of a Lifetime Annuity

A 65-year-old male who invests $100,000 into an inflation-linked annuity would receive annual payments starting at around $5,400 and increasing by inflation each year. This is a certain income stream that can be relied upon until death.

This is unlikely to generate a larger pile of cash than, say, $100,000 worth of growth assets held over the same period of time. That brings us back to the argument to include a range of retirement solutions, such as growth assets for their higher return, cash for liquidity and short term needs (three to seven years), superannuation for its tax effectiveness (with perhaps the growth assets and some cash held in the superannuation fund), extra cash to take advantage of the opportunity to buy in a significant downturn, and possibly an annuity to help manage longevity risk and inflation – there are a range of solutions that can be put together.

Conclusion

There is something almost understated and old fashioned about annuities – they seem to be products from the era of life insurance companies in the middle of last century.

However, the lack of the perfect retirement solution means there might well be a place for an annuity amongst the different options available -- a solution that means that part of your portfolio is protected against inflation and longevity risk, while perhaps providing greater access to the age pension.

For more on annuities, see also Elizabeth Moran’s article Higher Interest Rates And Annuities.