Category Archives: Annuities

Life annuity retirement income

Risk of Living too Long negated through life annuity

Ensuring retirement income stream over remainder of one’s life is the key purpose of the superannuation system.  The benefits of taking out a life annuity are explained but, for the reasons given below, it is quite rational, that people in Australia decide not to purchase an income stream in the form of an annuity.

The provision of the Australian Government Age Pension provides the ultimate protection against longevity. This leads one to avoid the more costly approach, the purchase of a life annuity, to cover one’s risk of living too long and thus running out of retirement income.  A generally conservative investment strategy and margins deducted from returns detract from the efficiency of life annuities by reducing returns.

Conservative investment strategy

To provide a long-term income stream for life, requires the issuer of a life annuity to invest in assets that are highly likely to be around in many years’ time. These assets are therefore required to be secure and accordingly have a commensurately lower rate of return.

Margins to cover capital charges

The issuer of a life annuity is required to hold capital, to offer the protection against risks, insolvency and liquidity, and the providers of such capital require a return on their capital.  Margins are therefore taken out of the asset returns, to compensate the providers of capital, reducing the return available to the life annuity holder.

Margins to cater for improvements in life expectancy

The uncertainty of improvements in the life expectancy of the general population is a risk that is borne by the issuer of life annuities.  An additional margin therefore has to be allowed out of the returns on all assets to allow for this possibility.

The lower returns from the conservatively invested assets and the margins deducted from such returns results in lower income streams while the risk of the annuity provider failing remains with the owner of the annuity.

In early retirement, while well-being allows for a full lifestyle, the life annuity holder will under spend, and not have access to capital.  Conversely, in very old age when lifestyle needs are far lower the annuity income remains and access to the Age Pension is also available.  Thus the life annuity has come at a very real cost to the holder by having invested conservatively, carried all the margins to compensate the life annuities issuer for the risks.  The net result of funding retirement income through the use of a life annuity results an under spending in the early years of retirement and then when lifestyle needs reduce significantly, at very old age, a level of income remains that cannot used, other than to leave by way of bequest, which is not the purpose of superannuation.

Further reading:


What is a life annuity contract?

The key feature of a life annuity contract is that it is payable for a person’s lifetime.  The basic requirements of a life annuity contract are set out in the description and purpose of an annuity that is payable for the lifetime of the owner. Below is an explanation of the parties to an annuity contract as well as the various options available to you to allow you to tailor your annuity contract.

Parties to an annuity contract

A life annuity contract is created when you pay a lump sum to a life annuity contract issuer and agree on the terms of payments to be returned to you at regular intervals over your lifetime. The issuer of life annuities is usually a Life Insurance Company. The purchaser of an annuity is the person who wishes to receive the regular payment. The person who receives the regular payments of an annuity is referred to as the annuitant. The annuitant might be two people in which case they are referred to as joint annuitants. There are occasions where the purchaser of an annuity and the annuitant are different persons.

There are two different kinds of annuities:

  • Guaranteed annunities
  • Equity linked annuities

Guaranteed annuities explained

Guaranteed annuities are the traditional annuities and the older of the two under which the promised benefits are 100 per cent guaranteed by the issuer. Under a guaranteed life annuity, the level of income promised to the annuitant is based on the long term prevailing market interest rate at the time the annuity is purchased. Under this kind of annuity, the regular annuity is payable for the lifetime of the annuitant or another person.

Equity linked annuities explained

An equity linked annuity offers no guarantee of what you will earn from your annuity because the underlying investments from which the annuity is paid by the insurer is invested in equities or unit trusts and the return on these is uncertain. Equity linked annuities offer no certainty of income or the term over which the regular payments are receivable. The annuitant carries the risk.

Options available for guaranteed annuities

The initial payment for the annuity determines how much will be paid out as an income stream. The age of the person receiving and the annuity and their life expectancy determines the level of income they will receive. An older person will receive a higher income because of a lower life expectancy.

With reference to guaranteed annuities, the individuals can decide which of the following is important to them.

  •  the period over which the annuity is payable
  •  frequency of the income payments, and
  •  whether the payments escalate or reduce.

An annuity can be payable for a person’s lifetime or may be limited to a certain period. If it’s limited to a certain period, the income stream will generally be higher.

When you purchase an annuity, you can choose to have regular payments made annually, bi-annually, quarterly or monthly. Annuities are generally paid in arrears and less frequent income payments will result in slightly better income levels.

At the start, you can choose whether the life annuity is to change in line with changes in the consumer price index. Furthermore, if you have chosen a joint annuitant, you may elect a reduced annuity to be paid to the surviving joint annuitant on your death. By electing a reduced income for the second annuitant, you will benefit from a higher income stream initially.

External information

MoneySmart definition and description of annuity

Longevity Risk – lifetime uncertainty

Insurance against longevity

Longevity, is one of the imponderables to consider, when one reaches retirement.  This question is how long will you live?  Real problems arise when having contributed into superannuation and now a superannuation lump sum is available to you but, it has to last an indeterminate lifetime. One option available is to apply the lump sum to purchase a guaranteed life annuity.

Starry Night Over the RhoneA guaranteed life annuity pays out every year until, the annuitant specified under the contract, dies.  A life annuity is therefore a compelling product as it “insures” you against longevity—living a long time, and thus risking running out of retirement income streams, while you are enjoying a long life.  A guaranteed life annuity  thus reduces the financial risk that comes with living into old age.

Risk of living too long

An annuitant living too long, beyond normal life expectancy, will accordingly gain from having taken out a life annuity. You will have protected yourself against the adverse financial consequences of longevity.  Guaranteed life annuities are therefore very attractive to the healthy, as an income stream is guaranteed for the whole of one’s lifetime.  Life expectancies for Australians are among the longest in the world and forecast to increase further but generally, people do not appreciate what their life expectancy is. This eliminates some of the financial implications of longevity, but the unhealthy could expect to lose out from buying a life annuity.
The result is that in entering into a life annuity contract there is a fear that the issuer of the annuity will fail, alternatively that the annuitant will die, very soon after taking the contract, the result being a windfall for the insurance company. In any event, the annuitant will lose the outstanding balance of one’s capital at death. Thus taking a life annuity is generally seen as a gamble.

Safety of annuities

However, issuers of annuities are life insurance companies, that are well regulated by the Australian and Prudential and Regulatory Authority, and are required to hold their assets in segregated funds. Furthermore, Life Insurance companies make adjustments to the contracted level of income through margins to run their operations, cover the risk associated with the assets backing the life annuities and to cater for an adverse selection against them were their life annuity products are taken by those who are more healthy than the general population.

Risk of dying young

An option available to purchasers to address the risks they perceive is to take joint and survivor guaranteed annuities. This annuity is issued with reference to the life of the annuitant and a dependant of the annuitant, usually the spouse. The annuity is guaranteed to be payable during the life of both the annuitant and continue for the lifetime of the joint annuitant.
Joint and survivor annuities may be structured to pay a constant amount throughout the lives of the two persons, or alternatively there may be a reduction in the annuity income level after the death of the first dying. This results in higher income levels to be paid initially.

Protecting capital in annuity

Although the focus of life annuities is to address longevity risk you may unnecessarily forfeit your capital if you die prematurely.  To overcome the aversion to possibly losing capital, in the event of premature death, life annuity issuers have been offering a withdrawal guarantee for a substantial portion of the capital for and initial time of up to 15 years.

Does downside protection have its downside?

Further reading:


What is an annuity?

An annuity is a financial product paying an income stream to the buyer for a period of time.  The income stream is paid monthly (or quarterly, semi-annually , or annually).

The person receiving the income is usually the buyer or, spouse or, children of the buyer. An annuity contract usually includes a  purchaser, an issuer of the contract, usually an insurance company. When purchased with a superannuation lump sum the recipient of the regular income is restricted to the buyer or spouse.

Purpose of annuity

These contracts are usually intended to pay an income for the life of the person or lives of two persons .  The term of the the income stream may however be fixed, such as 10 years.  When an annuity is arranged for the lifetime of a person the arrangement is referred to as a lifetime annuity.  The term for which the regular payments will therefore be paid for is the uncertain lifetime of the annuitant (the person entitled to the income).  This is the key benefit of an annuity.

Benefits of annuity

The benefit is that the person receiving the income stream will receive a fixed payment over a period of time.  They know exactly how much they will receive and when.  If taken for life then the annuitant cannot outlive the income stream.  If an annuity is taken out to last the lifetime of the persons receiving the income stream and they live longer than expected it will be to their advantage. This is the unique benefit of an annuity—it eliminates the risk of personal longevity.

Risks of an annuity

As the income stream is fixed, with inflation, it will not maintain its purchasing power.  If the person receiving the regular income dies soon after entering into the annuity contract, some of their money will have have been forfeited to the issuer. So there is no protection of income against inflation and there is no preservation of capital.