Category Archives: Annuities described

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:

Moneysmart 

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.