This fact sheet provides additional information to help with understanding the investment, tax and other financial planning concepts that we have discussed with you or included in your Statement of Advice.
Please contact your adviser if there is any aspect on which you need further information or clarification.
What is an annuity?
An annuity is a contract, typically with a life insurance company, that allows the purchaser to exchange a cash lump sum for a regular stream of income payments over the selected term.
The income stream is paid without reference to changes in interest rates and investment markets, providing a degree of certainty and security to future cash flow requirements.
Features of annuities currently available in the marketplace vary greatly. Key features and options include:
- funding with superannuation or non-superannuation monies
- receiving income payments for the full life of the annuitant, or a fixed term
- receiving level payments or indexing payments to inflation
- linking income payments to single life or including a reversionary annuitant
- electing the amount of capital that the annuitant or their estate will receive at contract expiry
- varying levels of capital access during the term of the annuity
- advantageous assessment for Aged Care and Centrelink benefits
These features combine to drive the level of regular income that the annuitant receives under the annuity contract.
An annuity purchased with superannuation is for the benefit of the superannuant only. In contrast, an annuity purchased with regular savings allows for the income to be paid to single or joint recipients, allowing the annuitants to split their income for tax purposes.
Types of Annuities
There are two common types of annuities.
- Lifetime annuities pay an income stream until the death of the principle annuitant (the Purchaser) or a reversionary annuitant (e.g. their spouse) as specified at the time of purchase.
- Fixed-term annuities pay an income for a period agreed upon at commencement.
Lifetime annuities
Under a lifetime annuity contract, the annuitant receives the agreed level of income until their death, irrespective of whether they reached their life expectancy or not. The annuitant can extend the contract to include a reversionary annuitant.
In its simplest form, the annuitant bears the risk that they and any reversionary annuitant may die earlier than the life expectancy tables predict. The earlier death occurs, the lower the total payments received will be.
A guaranteed payment period enables the purchaser of a lifetime annuity to obtain some protection against early death. Lifetime annuitants may select a guaranteed payment period at the commencement of the annuity, usually in whole years for a maximum of 20 years, or life expectancy at commencement (whichever is lesser).
If the annuitant and any reversionary annuitant die before the end of this guarantee period, the provider calculates the present value of remaining income. The provider pays a lump sum to the beneficiaries of the estate of the annuitant or reversionary annuitant. It may also be possible for the beneficiaries to receive the annuity payments until the end of the guarantee period.
If the annuitant and any reversionary annuitant die after the expiry of the guaranteed period, the annuity contract expires, and the provider is not required to make further payments.
Fixed-term annuities
The provider may return all or part of the lump-sum used to purchase a fixed-term annuity to the annuitant at the end of the agreed term. The amount of the lump-sum to be returned is the Residual Capital Value (RCV), which is expressed as a percentage of the initial purchase.
The annuitant can request for capital to be returned over the life of the annuity, in the form of higher regular payments. The higher the regular payment, the lower the RCV at the end.
At the end of the fixed term, the annuitant can choose to roll over the RCV to another annuity or have the RCV paid out. An RCV from an annuity purchased with ordinary money is simply a return of the original capital and is not taxed.
Because a fixed-term annuity has a guaranteed term selected at inception, no 'guarantee period' is required. If the annuitant passes away during the period, the provider pays the remaining payments or the present value of remaining capital and income payments, to the beneficiaries.
Centrelink treatment
Centrelink classifies annuities as "asset-tested income streams" for Centrelink assessment purposes. There are three types of annuities to be considered for Centrelink assessment.
- Short-term
- Long-term
- Lifetime
Short-term
An annuity is classified by Centrelink as a short term annuity when the term at purchase date is five years or less, and it is not either a long-term or lifetime asset-tested income stream (annuity)
A short -term annuity is treated as a financial asset for the income test and assessed under the deeming provisions.
For the assets test, Centrelink uses the purchase price, RCV, the term of the annuity and the amount of time that has elapsed since the annuity's start date to calculate the asset value.
Long-term
An annuity is classified by Centrelink as a long term annuity when
- the specified term of the annuity is more than five years, but not for life, or;
- the specified term is less than five years and is equal to or greater than the purchaser's life expectancy, or:
- the annuity pays a guaranteed income for the life of an individual and was purchased before 1 July 2019
Centrelink adjusts income payments from a long-term annuity to recognise the initial purchase price, before including the payments in the income test.
For the assets test, Centrelink uses the purchase price, RCV, the term of the annuity and the amount of time that has elapsed since the annuity's start date to calculate the asset value.
Lifetime
An annuity is classified by Centrelink as a lifetime annuity when
- the annuitant purchased the lifetime annuity after 1 July 2019, and
- the annuity ensures that, once it starts paying income, it continues to pay for the remainder of the annuitant's life, and
- the amount of payment considers the age, life expectancy or other factors relevant to the mortality of the annuitant
The Centrelink assessment of lifetime annuities for the income test and asset test depends on several factors including age, the use of superannuation or non-superannuation money, RCV, purchase date and life expectancy.
Outcomes are highly dependent on individual circumstances, and prospective annuitants should seek personal advice to confirm their position.
Complying annuities
Complying annuities are lifetime annuities issued before 20 September 2007 that meet certain conditions and enjoy a 100% or 50% exemption from the Centrelink assets test. No new complying annuities have been available since 20 September 2007.
Benefits
Despite the certainty and stability of guaranteed payments, when contemplating retirement, retirees often overlook annuities in favour of account-based pensions and other retirement income sources. Older annuity contracts with limited access to capital and restrictive terms, as well as the low-interest environment, may be to blame.
However, modern annuities can play an essential part in the retirement income mix for some retirees, given Centrelink, aged care and estate planning benefits.
For example, a lifetime annuity can assist a retiree in becoming eligible for a part pension, or increase their current part pension entitlement.
The sheltering of part of a lifetime annuity from the income test and assets test can also reduce the cost of aged care.
On fixed-term annuities, there are estate planning benefits, including:
- if purchased with ordinary monies, annuities can be paid straight to a nominated beneficiary on death, avoiding the estate and potential challenges
- the annuitant can stipulate that their nominated beneficiary receives the benefit as a regular payment, which is useful where the beneficiary may be unable to manage their financial affairs.
Dependent on the funding mix and commercial objectives of the product provider, fixed-term annuities may pay a higher level of income than term deposits and other money market instruments of similar term and risk.
Risks
Income is guaranteed over the specified period, irrespective of the investment performance of the assets supporting the annuity. Therefore the market and investment risk resides with the provider, and not the annuitant.
The annuitant does, however, bear counterparty risk. Annuities are provided primarily by life insurance companies, with payments from the life offices' statutory fund. In extreme circumstances, the provider may not have the capacity to meet its payment obligations.
The Australian Prudential and Regulation Authority (APRA) regulates life insurance companies. To minimise this counterparty risk, APRA requires them to hold 'reserves' and meet solvency and capital adequacy tests to ensure that they can meet all future liabilities.
Annuitants also bear interest rate risk when purchasing an annuity. Interest rates, amongst other things, underpin the level of income that is offered by the provider when setting the terms of the annuity. If interest rates rise during the annuity term, the annuitant suffers an opportunity cost. They may also suffer a capital loss should they decide to commute the annuity early, and interest rates have risen.
Finally, annuities are not as flexible as other retirement income stream products, such as account-based pensions. There may be restricted access to capital throughout the term of the product and reduced or no capital amount to be commuted or distributed to beneficiaries on death.
Important Information
Walbrook Wealth Management is a trading name of Barbacane Advisors Pty Ltd (ABN 32 626 694 139; AFSL No. 512465). Barbacane Advisors Pty Ltd is authorised to provide financial services and advice. This post is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or needs, unless expressly indicated otherwise. You should consider whether the information is suitable for your circumstances and where uncertain, seek further professional advice. The author has based this communication on information from sources believed to be reliable at the time of its preparation. Despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice, and we are not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, we accept no liability for any loss or damage as a result of any reliance on this information.
