In light of the key risks faced by Australian retirees trying to secure a comfortable retirement, a growing number are finding the benefits of annuities as attractive in building a retirement portfolio.

Planning for retirement is difficult because you face a number of key uncertainties:

• Protecting against the effect of market downturns on your retirement
• Maintaining your standard of living as prices increase over time
• How long money needs to last, when life expectancies are continuing to improve

What is an annuity?

An annuity is, in its most common form, a simple, secure financial product, which provides you with a series of regular payments in return for an up-front investment. The return you receive is fixed at the outset, and therefore is not affected by share market or interest rate movements. The regular payments generally include both interest and re-payment of your capital, but there are also options that return your up-front investment on maturity.

There are two types of annuities currently used in Australia:

Term annuities: Fixed payments are made for the length of the term (from one year up to 50 years). If your initial investment is returned at maturity, these have similar features to a term deposit. Longer maturity term annuities usually return the capital over the period in order to increase the regular payments.

Lifetime annuities: A lifetime annuity simply lasts as long as you do. Payments will continue for as long as you (or your reversionary if you appoint one) are alive. These payments can be increased with inflation in order to help maintain your standard of living. Many lifetime annuities purchased today also enable access to your initial investment for a period, and even a death benefit, so if you don’t end up living a long time your estate will receive the remaining capital.

Cash flows from an annuity in Australia are generally secure. Life companies must put aside additional capital to protect your payments and are subject to prudential supervision by APRA, which is also the regulator of superannuation funds and banks.

An annuity can be a safe way to use your savings to meet your income needs in retirement because you no longer have to worry about some of the key retirement uncertainties. You are guaranteed a fixed investment return, the regular payments can increase to protect your standard of living, and payments can be guaranteed for life.

How can annuities be used?

An annuity provides secure regular cash flows. A term annuity can be used in an SMSF to meet pension payments and other cash flow needs for a period of time. This enables the remainder of your super to be invested in the market helping to reduce the need to draw it down, maximising your portfolio’s growth opportunities. This is the bucket strategy I described earlier this year.

Lifetime annuities or term annuities with a long maturity can be used to provide a layer of secure income. This approach helps ensures that you have a secure income source for retirement needs, but maintain more flexible investments for the remainder of your spending. This is known as the income layering approach.

The idea here is to protect yourself from having to rely solely on the Age Pension should you live a long time or a market downturn depletes your savings.

The income layering approach

The Age Pension and guaranteed income investments can help secure essential spending as illustrated by the lower green bars on the chart. The annuity is an option for the secure income layer.

The strategy then looks to market-linked assets to maximise discretionary spending. SMSF retirees will likely have savings above what is required for essential spending and can afford additional discretionary spending throughout retirement. This is represented by the blue section of the chart.

This layer is subject to the market and may include options such as account based pensions.  How long these assets last will depend on market returns and the level of spending each year.

Case study: income layering for SMSF retirees

(See Accurium’s research paper, Accurium SMSF Retirement insights: Pension strategies for SMSF retirees, for further details on this modelling. Based on modelling carried out as at February 2016.)

SMSF trustees Adam and Jess are reviewing their retirement strategy. They are concerned about the impact on their lifestyle if financial markets crash, or if they live a long time. They desire security so that they won’t end up relying solely on the Age Pension.

The table below illustrates how Adam and Jess might implement an income layering strategy to help secure their essential spending for life. They do this by addressing the difference or ‘gap’ between the full Age Pension and their essential spending requirement with a guaranteed income investment. In this example this means fixing an income of $24,933 p.a. with a lifetime annuity.

Adam and Jess statistically have a 10% chance of running out of money and relying on the Age Pension if they make no change, so their essential spending is not secure.

Alternatively, by addressing the gap between Age Pension and their essential spending with a guaranteed income product there is statistically a greater than 99% chance their essential spending will be secure for life.

Could an annuity complement your retirement portfolio?

Many Australian retirees are increasing their peace of mind by adding an annuity to their retirement portfolio. Having greater certainty that essential spending will be secure for life allows you to manage your remaining assets with greater confidence that should markets turn against you or you live a long time you will not have to rely solely on the Age Pension.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.