What is an annuity and how does it work?

What is an annuity?

An annuity is a retirement product that provides you with a stream of income in your retirement years. But unlike an account-based pension, which draws from a balance that fluctuates with the markets, an annuity generally pays you a fixed amount at set intervals. This could be useful if you want to ensure steady income for everyday costs throughout your retirement.

How does an annuity work?

An annuity from a life insurance provider or super fund can provide you with monthly, quarterly, half-yearly or yearly income payments. You can buy an annuity using money from your regular savings or your superannuation, provided you’ve reached your preservation age and meet a condition of release, such as permanently retiring from work.

The amount you’re paid by an annuity mostly depends on how much money you’re willing to put towards it. The more you invest, the more you’ll get in return. These payments will continue for either an agreed term (known as a fixed term annuity) or for as long as you live (known as a lifetime annuity).

Your annuity can be set to increase each year, generally in line with inflation or by a fixed percentage. Annuities can be structured to return your investment earnings at the end of the agreed term, in regular payments over the agreed term or your life, or a combination of these.

When considering an annuity, you’ll need to look at what might and might not work for you. Getting professional financial advice on a range of retirement income products might be worthwhile.

How are annuities taxed?

Any money you get from an annuity bought with super money is tax-free from the age of 60, according to Moneysmart. If you’re between 55 and 59, then any annuity payment may have a taxable and non-taxable component.

If you’re looking to buy an annuity with money other than from your super, then you’d be wise to seek some independent financial advice before doing so. Plus, an annuity forms part of your income and asset test when considering your eligibility for the Age Pension.

What happens to an annuity when you die?

When you buy an annuity, you’ll have the option to either nominate a reversionary beneficiary or select a guaranteed period.

With a reversionary beneficiary, the beneficiary you have nominated (a spouse or dependent) will receive your income payments for the rest of their life, typically at a reduced level of the income you were receiving.

If you choose the guaranteed period option, your beneficiary will get your full payments, either as a lump sum or income stream (for a set period) after you die.

Why choose an annuity: the pros and cons

Pros of annuities

• Consistent income: While an account-based pension which is generally a market-linked investment that can go up and down in value, using an annuity means a market crash won’t affect your retirement income.

• Won’t run dry: If arranged to last for the entirety of your life, an annuity will provide you with consistent and steady income until you pass away, unlike an account-based pension that can be depleted to zero before the end of your life.

Cons of annuities

• Lower returns: While market-linked investments (a pooled investment scheme by multiple investors, in which the value of the investment is reliant on market movement) are inherently risky, they also have the potential to earn higher returns compared to more secure investments such as an annuity.

• Less flexible: Annuity providers generally don’t like you to access your funds before the end of the term, but they do recognise that there may be times when you need to deal with unexpected expenses. Even if your provider allows you to withdraw your funds entirely and cancel your annuity, it’s unlikely you’ll receive the full remaining amount.

• Fewer investment options: Annuities generally don’t give you a say over where your money is invested, which could be a concern for those concerned with ethical/green investing.

• Death benefits may be limited: While term and lifetime annuities generally feature death benefits payable to your estate or dependants in the event of your death, this feature might be limited in some circumstances or for a certain period (typically your life expectancy for a lifetime annuity). Another potential alternative could be comparing life insurance policies.