What is an annuity and how does it work?

What is an annuity?

An annuity is a form of retirement income product, meaning it provides you with a stream of income in your retirement years, similar to an account-based pension. 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 can be bought from a life insurance provider or a super fund. It’s designed to provide you with income payments that can be made to you monthly, quarterly, half-yearly or yearly. You can buy an annuity using money from your superannuation or your regular savings. To be able to buy an annuity using funds from your superannuation, you must have 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). 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.

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.

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 the Australian Government’s Moneysmart website. 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. In addition to this, an annuity forms part of your income and asset test when considering your eligibility for the Age Pension

→ Read More: Age Pension rates: How much is it and how does it work?

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

Annuities have features that can make them an attractive option compared to superannuation or an account-based pension.

The pros of annuities

Payments from annuities are guaranteed; meaning that unlike an account-based pension which is generally a market-linked investment that can go up and down in value, a market crash won’t affect your retirement income. With an annuity, you have a reliable, secure income for either the rest of your life or the planned period.

If arranged to last for the entirety of your life, an annuity will provide you with consistent and steady income until you pass away. This is one of the most significant benefits of an annuity when compared against an account-based pension – which can be depleted to zero before the end of your life.

The cons of annuities

While proponents of annuities view their secure non-market-linked nature as a big plus, it’s also their main flaw in the minds of others. While market-linked investments (which is 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. Additionally, annuities present several issues of liquidity and flexibility.

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. Check to see what their rules are with regards to withdrawing any of your funds early. If you decide to withdraw your funds entirely and cancel your annuity (if that’s allowed by the provider), it’s unlikely you’ll receive the full remaining amount. You also have no say over where your money is invested if you put it into an annuity. For those concerned with ethical/green investing, this could be an issue.

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). If you’re interested in other products that provide benefits to your beneficiaries when you pass away, then it may be worth comparing life insurance policies.

If you want a retirement income stream that provides you with maximum flexibility and you’re willing to deal with market-related risk, sticking with a regular account based pension may be a more appealing option to you. Or, like many Australian retirees, a combination of an account based pension and an annuity to guarantee part of your retirement income might do the trick. But remember to seek your own independent financial advice to see what options best suit your own circumstances.

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