Shani Jayamanne: Welcome to another episode of investing compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: All right Shani, so I went to the pub last week.

Jayamanne: Surprise, surprise.

LaMonica: And a listener recognised me which is very nice.

Jayamanne: Yeah

LaMonica: Which was very nice.

Jayamanne: That is nice. So where were you?

LaMonica: I was at the Sussex – which is down by our office in Barangaroo.

Jayamanne: This is where you conduct meetings sometimes.

LaMonica: I have not done that while Shani, but yeah somebody came up and talked to me.

Jayamanne: But when people do come up to us and talk to us about the podcast, first of all it's very nice, but secondly one of the most common questions we get, is whether we're actually friends.

LaMonica: So what's the answer Shani?

Jayamanne: What do you reckon mate?

LaMonica: Well you're my friend but you seem to hold me in, you know, mild distain.

Jayamanne: We’re friends, we’re friends. Should we move into this topic?

LaMonica: We should – it's a topic for retirees.

Jayamanne: Okay.

LaMonica: Or anyone who ever wants to retire. So retirees have been on a bit of a rollercoaster as we all have in the last few years, but record low interest rates, consistently rising interest rates. High inflation. Huge gains on the share market. Huge falls in the share market.

Jayamanne: And part of investing is risk. We’ve spoken about the equity risk premium before, but it is the price that we get paid for taking on risk.

LaMonica: That’s right Shani, and guaranteed income is the holy grail for income investors. The trade-off that we make as investors when we go out and buy shares is we’re exchanging risk for returns. And the risk we are speaking about is volatility, or how much an investment bounces around. The more volatile the investment the more return we should expect. That is why shares change in price more than cash but also they have higher returns.

Jayamanne: When we look to guaranteed income, there are a few investments in the fixed income space that offer this for investors. In exchange for guaranteed income, the return is lower than what investors could expect from equity investments. And one of these investments is annuities.  

LaMonica: And annuities are interesting investments because they can be sheltered from interest rate movements. They can be sheltered from inflation. They can be sheltered from market movements. It’s just guaranteed income.  

Jayamanne: And in exchange for guaranteed income, you give up your capital for the most part.  

LaMonica: Alright so, that’s going to need some explaining of course - which is the whole reason we picked this as a topic. So why don’t we start at the beginning Shani. What is an annuity? 

Jayamanne: So annuities offer a fixed stream of payments to an investor. This stream can be for a fixed period, or for their lifetime. These are called lifetime annuity payments and these annuities are what we’ll focus on today. As we alluded to earlier, these payments can also be linked to CPI, so you’re protected against inflation eroding your purchasing power. 

LaMonica: And annuities can be purchased by anyone. But they are, particularly popular for investors in retirement. One of the unknowables with retirement is how long you’re going to live for, and therefore how much you will have to save to provide for yourself. This guaranteed payment, especially with lifetime annuities, offers investors peace of mind with retirement if they are receiving a regular income stream until death. 

Jayamanne: So how do they actually work? Well, it’s difficult because it’s sort of calculated like an insurance policy. The annuity provider takes into account your age, your gender, your life expectancy – there are a number of variables that determine the regular payments that you receive, but a large part of this is obviously how much capital that you’re foregoing. And then if you want to add on something like inflation protection you can do that – for a price. The price just means you get a lower amount of guaranteed income.  

LaMonica: So we’re going to use an example to give you an idea of how much they pay and how it works. We’re going to use Challenger, they are one of Australia’s largest annuity providers, we’re going to use their lifetime annuity as an example. And this data is from the 25th of May 2023.

Jayamanne: So if you are a female investor who is aged 65, for every $100,000 you invest, you’ll receive $4,740 if you go for full inflation protection. This protects you from up to 8% inflation increases per year. If you go for no inflation protection, you’ll receive $6,565 per $100,000 invested.

LaMonica: If you are an 80-year-old female, you’ll receive $7,727 per $100,000 per year for full inflation protection. You’ll get $9,405 for no inflation protection.

Jayamanne: So if you are a 65 year old female who invests $300,000 of their portfolio, you’ll receive $14,220, adjusted for inflation, each year. To make back your principal, it would take 21 years.

LaMonica: Of course, that is not taking into account inflation, or the opportunity cost of investing it elsewhere.

Jayamanne: So in exchange for this income, you’re giving up your capital. And that is one of the downsides to annuities. There are no partial withdrawals. So if you require a lump sum due to an emergency, equities allow you to sell, even at a loss. Cash is liquid. Annuities do not allow partial withdrawals. What they do allow is withdrawals during the withdrawal period.

LaMonica: So you are allowed to withdraw your capital, plus not be penalised in most instances for the income that you have received. This withdrawal period changes due to your circumstances, but if we take the 65-year-old female example, it would be 22 years. For an 80-year-old woman, it would be 10 years. This is using the Challenger lifetime annuity product.

Jayamanne: So there is some flexibility within the first part of your annuity, but that disappears as you get older and your capital is locked in. Related to this, one of the most common questions asked about annuities is what happens to the capital after you die?

LaMonica: Exactly, Shani. You want to make sure you get your money’s worth before you die. The purpose of an annuity is to give up your capital to receive guaranteed income. If you die prematurely, a death benefit will be paid out to your beneficiaries.

Jayamanne: And when we say prematurely, again it is relative and it’s determined based on the age that you take out your annuity.

LaMonica: In some cases, a death benefit is a full refund of the initial premium so as well as guaranteed income, some investors consider this as insurance against premature death.

Jayamanne: Let’s give an example of this. The example is a retiree at 75. They would receive their capital back if they died within 10 years, on top of the interest payments that they have already received. Then, there would be a reducing death benefit that is based on life expectancy.

LaMonica: Okay – let’s talk about who annuities might suit. When we look at asset allocation, as an asset class, annuities would fall into cash and fixed income.

Jayamanne: As we ran over briefly - unlike equities, annuities are not impacted by share market movements. If this is something that appeals to you, there are certain products where you can elect for them to be linked to share market movements. But this defeats the purpose of an annuity for us. The whole purpose is guaranteed and predictable income.  

LaMonica: And unlike most fixed income, they are not impacted by interest rates. This means that retirees don’t have to worry about issues such as sequencing risk and longevity risk – two of the major concerns in retirement.

Jayamanne: And just as a reminder, sequencing risk is the risk that the order and timing of your investment returns are unfavourable, resulting in less money for your goals. Sequencing risk is especially dangerous for retirement goals - Towards the end of the accumulation phase and in early retirement, your savings pool is generally at its largest, and is more exposed to market movements given the volume of capital at risk.

LaMonica:  And Challenger has a great example of sequencing risk. And of course you expect them to have a great example of sequencing risk because they are trying to sell you an annuity which protects against this risk. So this example is based on a retirement scenario between 1992 and 2019. The investor retired in 1992 with $350,000 split evenly between Aussie shares and bonds. Following her retirement, she drew down $22,000, indexed to inflation each year.  In 27 years, she would still have over $200,000 left based on the market returns that she achieved.

Jayamanne: Now – take that same investor but switch the order of returns between 2019 and 1992 – in reverse chronological order. The investor would run out of money in 24 years – completely down to $0. The sequence of returns during this period has a significant impact on the sustainability of her retirement income. When you’re getting close to retirement, a fall in market value of investments would leave the investor much less time to recover and increase the probability of a shortfall of funds in the late stage of retirement.  

LaMonica: Then, there’s longevity risk. And this is the risk that you run out of money before you die. A person might work from 20 til 60 – for forty years, and then live forty years. How do you prepare for that? How do you decide how much is going to sustain you through those years?  

Jayamanne: This is where annuities can give investors peace of mind.  

LaMonica: But - annuities are not meant to replace your entire income in retirement. They are meant to be a portion of your retirement strategy that provides a foundational guaranteed income, with other assets able to take on risk to drive returns.  

Jayamanne: Just like you wouldn’t have your whole investment portfolio in cash or fixed income unless you had an enormous base of capital that you were happy to live off the passive income from, you would want your money working harder than just putting all your money in an annuity.

LaMonica: And so when you have it as part of your portfolio, you might have it with equities, other forms of fixed income and cash. But you might also be in a position where you are receiving the aged pension.

Jayamanne: What you see with annuities is they actually have concessions for holding annuities and receiving the age pension.

LaMonica: If you invest in an income annuity on or after 1 July 2019, the pension rules will generally assess 60% of the purchase price of the lifetime income stream until age 84, subject to a minimum of 5 years; and 30% of the purchase price thereafter.

Jayamanne: It’s worth mentioning as well, a couple of logistics with annuities. You’re able to invest in annuities through your super or as a personal investment. If it is through your super, the regular concessions apply such as tax-free earnings in pension phase.

LaMonica: And if you have a partner, you’re able to jointly hold your investment if it’s invested outside of super. This means that you are able to split the income for tax purposes. If one of the owners of the annuity dies, the remaining owner is able to continue receiving the funds as an income stream (at a reduced rate), or a lump sum.

Jayamanne: So annuities can suit investors that want a guaranteed income in retirement. Are there any investors that it may not suit?

LaMonica: Yes – I think a significant consideration for annuities is whether investors want to leave an inheritance for their beneficiaries. After the withdrawal period elapses, there is no ability for you to pull out your funds, and the capital is paid in exchange for guaranteed income. This means that for the annuity portion of your portfolio, you would have no capital to go to your beneficiaries when you die.

Jayamanne: This of course might not be a consideration if the annuities portion of your portfolio isn’t that large. But once that withdrawal period is gone, your capital is locked in. 

LaMonica: And so with annuities, you are receiving a lower overall return over a long time period. You’re locking this return in, depending on what return they’re offering at the time you take on the investment, for 20-30 years sometimes. And there is a risk with this. Over those sorts of time horizons you do see equity investments blow the returns offered out of the water. You do lose access to your capital.

Jayamanne: But there’s a lot that investors are willing to give up for peace of mind from a guaranteed return.

LaMonica: There are multiple annuity providers in Australia. There hasn’t really been that much uptake here with annuities, and most of them are purchased for clients through financial advisers. The Actuaries Association of Australia quoted a study done by their American counterparts as to why investors don’t purchase annuities to the extent expected.

Jayamanne: The most common answers that were given were the loss in liquidity, the loss of a bequest when they die, low risk aversion – so retirees are willing to take on more risk for return and higher personal consumption rate. And basically what that is, is that people would rather consume their funds more when they are young and able – so to travel and to enjoy life, and don’t value a steady income stream that pays them the same amount throughout their whole retirement. They want the flexibility to draw down and use the amount that suits them.

LaMonica: Of course, as part of an overall portfolio, annuities can help investors do this. Another interesting answer was that investors have already got a guaranteed income through the age pension, so they don’t need two sources of guaranteed income. They would rather have the age pension come in, and put the money to work in a riskier asset class. This is a completely legitimate reason for foregoing annuities. Investors that have already met their income criteria from social security, cash and fixed income may find that annuities lower the risk of their portfolio below the range that they require to sustain their lifestyle.

Jayamanne: So we will end this episode by trying to provide a little personal perspective. And as a reminder we do this not as a guide for what others should do but as a way to show how personal circumstances inform all your investing decisions. So Mark, would you consider an annuity as part of your retirement planning?

LaMonica: I would Shanika. In my case I have no kids so I don’t have anyone that I would naturally provide money for as part of an inheritance. I am entitled to some social security as a result of the time I spent working in the US but I’m unlikely to qualify for the aged pension. So supplementing social security and covering a portion of my living expenses through an annuity is attractive. How much would be a product of the circumstances of when I actually retire. But I see this as just another way to diversify my income stream in retirement. You’re very close to retirement Shani, so how about you?

Jayamanne: I have been thinking about this a lot haven’t I? Yeah it’s difficult to predict where I will be in almost 35 years’ time when it comes to my retirement goals and savings. I think the main consideration I would have is whether I qualify for the age pension, or if I have any other guaranteed sources of income. I did miss the boat on defined benefit schemes. I think it’s important to remember that the payments you can get from an annuity are variable. They vary based on your age, your gender, your life expectancy. As your life expectancy increases, the income payments that the annuity provider has to guarantee increases. This naturally means that your income payments will reduce. Every year, Aussie life expectancy rises by a month. By the time I retire, there will be a significant impact on the income investors get from annuities. At retirement, I would assess the proposition that they would offer – they provide this when you apply for the product. This proposal includes the income payments, the withdrawal period, the maximum inflation protection that they offer. So that’s the long answer. The short answer is that I would love a form of guaranteed income, and depending on what else I have, I would consider annuities.   

LaMonica: Okay so when you’re listening to Investing Compass in 35 years, long after I’m dead and Shani’s still doing it with a better host, you can give the answer did you end up getting an annuity.

Jayamanne: Whether I invested in annuities, yeah.

LaMonica: Exactly, so stay tuned for that – 35 years from now. But thank you so much for listening, that’s our episode for today. We would love any ratings or comments in your podcast app, thank you.