What is an annuity and how does it work?

When planning for your retirement you might know all about account-based pensions, but how familiar are you with their close relative, annuities?

Annuities are a form of retirement income product, meaning they provide you with a stream of income in your retirement years, similar to an account-based pension.

But unlike account-based pensions, which draw from a balance that fluctuates with the market, an annuity generally pays you a fixed amount at set intervals.

That could be useful if you want to make sure you have enough funds for everyday costs, such as food and regular bills, throughout your retirement.

If that sounds like an attractive option to you, here’s what you need to know about annuities and their various pros and cons.

What is an annuity?

An annuity is a type of pension product you can buy from a life insurance company or a super fund with a lump sum. 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 purchase 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 are paid through an annuity mostly depends on how much money you’re willing to put towards buying it. The more you invest, the more you will get in return.

Those 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).

The investment company Challenger has an online calculator to show how a typical annuity works, but this is only a guide.

When considering an annuity you need to look at what might, and might not, work for you.

The Actuaries Institute’s Superannuation and Investments Practice Committee convener, Tim Jenkins, told Canstar it’s important people get independent advice on a range of retirement income products, including lifetime annuities.

“Financial decisions on retirement matters are critical and can have substantial, sometimes irreversible, and long-term impacts on an individual’s lifestyle in retirement,” he said.

The Australian Government’s MoneySmart website says an annuity forms part of your income and asset test when considering your eligibility for the Age Pension.

Your annuity can be set to increase each year, generally in line with inflation or by a fixed percentage.

Recent developments by annuity providers have also seen the ability to increase payments by changes in cash interest rates or by changes in different investment indexes.

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.

What happens to an annuity when you die?

When purchasing an annuity, you will have the option to either nominate a reversionary beneficiary or select a guaranteed period, according to MoneySmart.

With a reversionary beneficiary, the beneficiary you have nominated (a spouse or a 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

The major upside of an annuity is that once it’s arranged and paid for, you’re set.

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 comfortable retirement.

You’ve got yourself a reliable, secure income for either the rest of your life or the period you arranged for the annuity.

If arranged to last for the entirety of your life, an annuity will provide you with consistent and steady income until you die.

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.

But annuities do come with some downsides.

The cons of annuities

While proponents of annuities view their secure non-market-linked nature as a big plus, that’s also their main flaw in the minds of others.

While market-linked investments 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 life throws us challenges, and 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 this is indeed allowed by the provider), it’s unlikely you’ll receive the full amount still sitting in your annuity.

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).

You 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.

→ Read more: What is ethical investment in Superannuation?

At the end of the day, annuities are a secure form of investment, and that can be either a pro or a con depending on your individual circumstances and the kind of retirement strategy you’d like to pursue.

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 for you. But remember to seek your own independent financial advice to see what options best suit your own circumstances.

If you’re comparing Superannuation funds, the comparison table below displays some of the products currently available on Canstar’s database for Australians aged 30-39 with a balance of up to $55,000, sorted by Star Rating (highest to lowest), followed by company name (alphabetical). Use Canstar’s superannuation comparison selector to view a wider range of super funds.

Fee, performance and asset allocation information shown in the table above have been determined according to the investment profile in the Canstar Superannuation Star Ratings methodology that matches the age group specified above.

Cover image source: Studio Romantic/Shutterstock.com

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