Annuities – Income Streams
Long ago annuities were purchased by healthy, wealthy seniors as a means of converting lump sums into extended lifetime income streams. These folk were paid annuities as income streams. Annuities are now being marketed to retirees, so what is an annuity and why would I buy one?
The purchase of an annuity contract involves the purchaser paying a substantial amount of money to a life insurance company in exchange for an agreed series of payments in future years.
For example, a retiree could pay a lump sum of $100,000 now in exchange for an annuity payment to himself, or his estate, of $11,500 at the end of each of the next ten years. Thus the retiree has converted his lump sum into regular fixed payments and he does not need to worry about changes in interest rates or selling investments to provide basic spending money.
Another way of thinking about an annuity is to think of the annuity purchaser as the lender for a fixed rate home loan. If Mary lent her son $100,000 to buy a house and he paid her back in equal monthly instalments for the next ten years Mary would expect to get a similar pattern of payments as an annuity would provide.
The term of the annuity contract is the ‘pay back period’.
Fixed term annuities are generally purchased for terms of between 5 years and 15 years. If the owner of a fixed term annuity dies before all of the annuity payments have been received then the estate collects the remaining payments on their due dates.
The ‘term’ for a lifetime annuity is for as long as the insured life, usually the person who bought the annuity, is alive. The payments under a lifetime annuity stop as soon as the insured life stops breathing.
The people who purchase lifetime annuities are usually those who expect to live a very long time. But even these folk might worry that they might not live to 100 years and hence they might ‘forfeit’ some of their money. Therefore, lifetime annuities are available with a minimum payment period.
For example, at age 80 years Joe is in good health and considers buying a lifetime annuity. Joe is concerned that whilst the average man of his age could expect to live for another 8 years, he would lose out if he was hit by a bus and only received 6 years of payments from a lifetime annuity. Joe decides to buy a lifetime annuity with a guaranteed payment period of 8 years. Joe accepts that the annual repayments are lower if a guaranteed payment period of 8 years is provided. If Joe lives to 99 years then he could be happy knowing that he got a good deal.
Payment Frequency, how often the annuities pay the income streams
Retirees have many regular expenses as we buy our food each week and our prescription medications each month. But other big bills come less frequently. Annuity contracts can have repayments at the end of each month, or once every 3 months, or every 6 months or only once each year.
There are costs involved in having repayments more frequently than annually. The amount you receive from twelve monthly payments is usually less than the amount you would have received if you just received one payment at the end of the year.
Variable Annuities when the annuities allow for increasing income streams
Annuity contracts can provide for the amount of the repayment to increase by, say, 3%, each year. The repayments under an indexed annuity start lower in the first year and increase at the agreed rate each year so that the final year repayment is much higher than under a fixed rate contract.
Security of the annuities capital and income streams
If I handover $100,000 to purchase an annuity, what security do I have that the annuity payments will keep coming into my bank account for the whole term of the annuity contract?
The only organisations allowed to sell annuity contracts in Australia are life insurance companies that are registered and supervised by APRA. Each year every Australian life insurance company must demonstrate to APRA that it holds enough financial assets to meet all of its commitments to policyholders, including annuitants.
Cashing in an annuity?
Lifetime annuity contracts cannot be ‘commuted’ for a lump sum, that is, cashed in. There is a 30 day ‘cooling off’ period starting from when you receive your annuity contract document from the life office. You may return the policy and receive a refund of your annuity purchase price during your cooling off period. Once the 30 days are over your contract really is ‘non-commutable’. You cannot ask for a lump sum payout when your health deteriorates and your prospects dim.
Your executors may choose to continue to receive the annuity payments for the remainder of the guaranteed or fixed annuity period. The life office could offer the executors the option of receiving a final lump sum payout in lieu of the outstanding guaranteed annuity payments.
Annuities as Income Streams at Centrelink
Centrelink treat most annuities for terms in excess of 5 years as ‘income streams’ not ‘financial assets’. As a result, the amount that Centrelink count as ‘income’ in respect of your annuity, for the Age Pension Income Test would be different from the deemed income in respect of the money still tied up in the annuity.
Prior to 20 September 2004, lifetime annuities and non-commutable annuities with a fixed term for the shorter of the purchaser’s life expectancy and 15 years were ‘exempt assets’ for the Age Pension Asset Test.
The exemption was reduced to 50% of the ‘value’ of the annuity for annuities purchased between 20 September 2004 and 19 September 2007. The exemption does not apply to any annuities purchased after 19 September 2007.
Annuities purchased before 20 September 2007 retain their full or part exemptions from the Asset Test.
Advantages of buying Annuities as Income Streams.
The main advantages of annuities as income streams are
During the earlier years of the contract, the Centrelink Income Test treatment of the investment is usually more favourable than for keeping the cash in the bank. This advantage could disappear if the deeming rates drop substantially.
You have certainty of income from your annuity investment. You do not need to worry about scheduling term deposit maturities or selling investments to generate spending money.
The main disadvantages of Annuities as Income Streamsare
You are locked in to your annuity contract and cannot change to higher yielding products when investment markets change.
If you buy a lifetime annuity but do not live very long then your purchase is subsidising other annuitants who do live to advanced ages.
The annuity provider, an Australian life insurance company, recoups its administration and marketing costs from your purchase price and charges you for providing the ‘guarantee of future payments’.
Annuities are complex financial products which do not suit everyone. Always obtain independent professional advice about your personal financial position before purchasing an annuity.
Financial Care Services is licensed to provide personal financial advice about annuities – call (03) 9808 0338 to make an appointment.
If you would like further confidential, independent and professional advice about Centrelink, lifestyle or financial issues please contact Christine Hopper (03) 9808 0338.
Financial Care Services – call (03) 9808 0338
Disclaimer: The information contained in this website is of a general nature only and does not constitute “financial advice”. You should obtain your own personal financial advice before investing any money or moving in to any retirement village, lifestyle community or aged care facility. Financial Care Services is licensed to provide financial advice to individual clients based on their personal situations. © 2012 Financial Care Services Pty Ltd. All rights reserved.
To make an appointment for professional advice, call Financial Care Services (03) 9808 0338