Annuities may not be an exciting topic but it is important to consider when trying to balance out the risk within a financial portfolio. Here’s what you need to know.
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If Australia was built on the back of sheep, the financial services sector was born out of the insurance industry that was built on the back of annuities.
Annuities were a tool of choice in retirement planning during the 70s and 80s and parts of the 90s after which they fell by the wayside and were replaced with the perhaps more exciting financial tools of managed funds, platforms and listed securities.
Many insurance companies got out of the business altogether arguing that they were to ‘capital intensive’ and most advisers simply forgot about them.
There is a resurgence of sorts going on at the moment as more advisers and investors are realising that annuities can be a powerful device when constructing a balanced portfolio.
Insights about annuities
1. You can design an annuity in many different shapes and forms
There is not one type of annuity. They can be indexed to a set number or to CPI or not indexed at all. They can be for one year or for 50 years or for one or both lifetimes. They can return all your capital at the end, or none of it or anything in between.
An annuity can be any number of combinations of the above and can be designed to perfectly fit strategy or your individual circumstances.
2. They can act as a term deposit
If you put $100,000 into a term deposit for one year you are in effect creating a one year, 100% RCV (Residual Capital Value) annuity. Annuities designed with these parameters are directly comparable to term deposits and can have higher returns.
3. Insurance product
An annuity can manage two types of risk. Inflation and life expectancy. In effect an annuity can provide insurance protection against these two risks. An annuity is an insurance product governed by insurance legislation.
4. APRA regulated
As they are insurance products they are regulated by APRA (Australian Prudential Regulation Authority). APRA is the prudential regulator of banks, insurance companies, superannuation funds, credit unions, building societies and friendly societies. This means APRA has transparency of the annuity provider’s capital position, asset holdings, business plan, and risk and capital frameworks.
5. Unique category of product
Annuities can be used as part of a diversified portfolio. All portfolios are made up of one or a combination of the three SPI ingredients.
S = Shares (all forms of ownership in business)
P = Property (all forms of ownership in real estate)
I = Interest (all forms of loans)
Annuities are part of the conservative Interest component of a portfolio. Unlike other interest based securities such as bonds, they are not volatile as there is no secondary market to reprice them.
A benefit of annuity is that you are paid a guaranteed income regardless of how markets perform
They also can provide a contractual inflation hedge linked to CPI that unique to annuities and some inflation linked bonds. The combination of no volatility plus inflation hedge makes then a unique category of investment.
6. What happens if I pass away?
There lingers a wide spread idea that if you die your family/estate ‘lose the money’ in an annuity. This is mainly untrue. In all form of annuities (except lifetime annuities) if you pass away the remainder of the contractual term is passed down and inherited.
In the case of lifetime annuities, you can choose to guarantee a certain period of repayments e.g. 15 years but after that if there is no reversion of the annuity to a partner, then any residual capital is forfeited. This does make sense as this is the risk inherent in an ‘insurance’ arrangement such as lifetime annuities.
7. Helping to solve the retirement tri-lemma
Annuities can be an effective tool in solving the dilemma of balancing a retirees Capital, Income and Longevity needs. It is a 3D problem that does not have a single solution and requires a broad use of multiple tools to solve. In fact, new legislation and new products are actually required to further our ability to deal with this. The need for Deferred Annuities is merely one example of that.
8. Contractual inflation hedge
Annuities can be used as a tool that provides a guaranteed, contractual hedge against CPI. If you think that CPI will be low in years to come and that the cost of living will rise faster than declared CPI, you can lock in an indexation number such as 4% per annum. This hedge could be for a long fixed term such as 15 to 20 years or for a lifetime.
9. Locking in a real rate of return and floating on inflation
In effect what you are doing with an inflation hedge is locking in a Real Rate of Return (RRoR) on your capital. This is not widely understood. If inflation is low then your gross return will be low, but if inflation is high then your gross return will also be high. The constant being your RRoR. In effect an annuity allows your real rate of return to ‘float’ on inflation.
10. Lifetime option
If you want to guarantee a small or large part of your income for the remainder of your life, you can do that using a lifetime annuity. If you want to make the same guarantee for your life and your partner’s life combined, you can in effect have a last survivors guarantee. Annuities are unique in their ability to deliver on this particular outcome.
11. Where they sit on the risk scale
Annuities sit just above a term deposit and just below an Australian bond fund in terms of risk. They are at the very conservative end of the debt (interest) securities spectrum.
12. Managing sequence risk
Sequence risk is the mismatch between a portfolio’s returns and the same portfolio’s cashflow commitments (typically pension payments). If you make a positive return every year you'll be able to meet your cash flow obligations from those returns. This risk plays out fully when it is at the beginning of the retiree’s retirement journey.
If the returns are negative in the early years of the portfolio while it is paying regular payments then it's almost impossible for the portfolio to recover and return to where it was before the market fell. Markets and your retirement are uncorrelated. Whether the market rises or falls just after you retire is entirely a matter of luck, or more precisely a function of when your parents met!
An annuity is a good choice if you want the security of a guaranteed income for a certain period of time. Seek financial advice to be certain it is the right choice for your needs and circumstances.
13. Negative compounding and unbundling cashflow
If your portfolio delivers a negative return in a year or a sequence of years but you still need to draw your pension payments, then the only way the portfolio can make these payments is by selling down assets and crystallising losses. Another term for this dynamic is negative compounding. Annuities are a good tool to ‘unbundling’ your cashflow needs from the actual returns of the portfolio.
14. Growth needs time to grow
This has a nice ring to it. It means that the growth part of your portfolio needs to be left alone and insulated from capital drawdowns for as long as possible to allow the strategy to come to fruition. Annuities can be a great device that deals with short and medium term cash flow needs while allowing other more volatile more growth oriented parts of your portfolio to be left alone to grow.
15. Disciplined capital consumption
If you use a Nil RCV annuity, at the end of the term there is no capital waiting for you. So where did it all go? The capital was returned to you in the form of higher regular payments made up of some capital and investment return.
In some strategies, this is perfectly fine as disciplined capital consumption over a long period of time is actually desired. But in cases where capital preservation is important then the growth components of the portfolio can replenish that consumed capital if the time line is long enough to allow that part of the portfolio to grow.
If you want to consume a controlled amount of capital within the portfolio over a long predetermined period of time there is no better tool to achieve that then long dated nil residual capital value annuities.
So let's say that out of a $1.5 million portfolio you wanted to consume $200,000 over a period of 15 years. A 15 year, CPI linked, nil RCV term annuity would help with achieving this outcome.
Capital consumption in its own right is not a problem as during that 15 years the growth components of the remaining $1.3 million could have replaced the $200,000 consumed capital.
16. Super, non-super or SMSFs
Annuities can be purchased in a multitude of ways. They can be purchased as a pension product (wrapped within an off the shelf superannuation arrangement) or they can be purchased with personal cash or they can be purchased within a family trust or SMSF.
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