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The term ‘Annuity’ is often mentioned in the financial press or TV advertising, but what actually are annuities and how do they work in practice?
The word annuity itself originates from the meaning ‘annual’ and can by definition, be described as ‘a yearly allowance’. To explain them in plain English is as a ‘really long term deposit, one where it is known exactly what the interest rate will be all the way along and when the payments will stop’.
Although many people may immediately think an annuity is locked away forever, that’s not always necessarily true. Like a term deposit an annuity can actually be cashed in before the term expires (even the lifetime ones in some cases). This may not always be the best course of action but don’t immediately disregard annuities if this is your main concern.
Annuities can play an important role in cash flow management, and can provide much needed certainty when stock markets are volatile and it seems like the rest of the portfolio is heading south.
They can also be used for different terms – from one year up to the day when we meet our maker. Annuities can be set up to pay 100% of the amount invested back when the term is over, or just some of it (if that meets a specific objective).
Let’s look at a simple example
Vicky is 62, retired, and knows she needs $35,000 to meet her annual income requirements. What she also knows is of that amount, $10,000 is enough for her basic ‘fixed’ costs – all the main bills, etc. The rest is her ‘lifestyle’ money. Her financial adviser recommends that she purchase an annuity to pay for these fixed costs.
The income is fixed, and (like the bills!) can be indexed to inflation. Vicky will then have the certainty that over her lifetime the annuity will always be there to pay the bills she has to pay – no matter what investment markets do, or even what the politicians decide to change. Her other everyday costs are covered by her pensions: the Age Pension and Account Based Pension from her super. All have a purpose and provide her with peace of mind, but perhaps none more so than the annuity. Saying that, the annuity is not going to grow 20% in value in any given year, but that’s not what it’s designed to do (it’s also not going to drop 20% either!).
It is generally accepted that the trade off for locking in the income from an annuity is that in the long term you are likely to underperform against market linked investments. There has also been a lot of criticism around the transparency of the underlying assets and how the funds are actually invested. The bottom line is that if you are relying on a company paying you an annuity for 30 years or more, you need that company to be around in 30 years time!
In many cases you can’t access your funds as a lump sum, which could be devastating should you need to, for example if there were major renovations required on your house, or large medical bills to contend with. If estate planning considerations are a large concern for you, some annuity products do not offer a lump sum pay out to beneficiaries.
We have the lowest interest rates for approximately 60 years, and this is currently translating to significantly lower interest rates being offered on annuities.
For me, annuities are very conservative products. Like fixing your interest rates with a bank, they provide security but history has shown that riding the variable rollercoaster tends to provide the superior return. This doesn’t mean that you should put all your assets into shares. Hudson are advocates of gaining exposure to all five asset classes and setting aside different amounts to different timeframes. If you are a very conservative investor, you could consider keeping enough funds in Cash and fixed interest (bonds etc) to provide income for ten years. But this will still likely leave plenty of funds to invest in shares and property, which have the history of providing larger returns.
If you are definitely going to purchase an annuity why not consider something similar, i.e. Buying a 5 or 10 year annuity, and leaving funds to invest in growth assets? And/Or, if interest rates rise over that time (which they likely will) you could then lock in another annuity at that time at probably a higher rate.