Powered by momentummedia
nestegg logo
Powered by momentummedia
nestegg logo
nestegg logo

Retirement

What is an annuity and how does it work?

  • September 08 2021
  • Share

Retirement

What is an annuity and how does it work?

By Zarah Mae Torrazo
September 08 2021

Having enough income for retirement is important. If you’re looking for an alternative source of income when you’re retired, an annuity may be the answer.

annuity retirement

What is an annuity and how does it work?

author image
  • September 08 2021
  • Share

Having enough income for retirement is important. If you’re looking for an alternative source of income when you’re retired, an annuity may be the answer.

annuity retirement

Annuities are insurance products that give retirees a reliable and steady income. These income payments can support your financial needs for the rest of your life or for a fixed number of years. 

An annuity can be a good foundation of your retirement planning. It can complement your other retirement investments and sources of income, such as your superannuation and the Age Pension.

In this article, we answer your most basic questions about annuity to help you understand this retirement tool. 

Advertisement
Advertisement

What is an annuity and how does it work? 

An annuity, also referred to as lifetime pension or fixed-term pension, is a type of pension product offered by life insurance firms and investment companies. You can also buy it from a super fund. 

This product works by transferring risk from the investor (called the annuitant) to the insurance firm. Similar to other types of insurance products, you pay the annuity provider premiums to carry this risk.

These premiums can be paid through a lump-sum amount (averaging $5,000 to $10,000 or higher in Australia) or through a series of payments, depending on the type of annuity you have availed.

What sets an annuity apart from other types of insurance is that you are not required to pay premiums indefinitely. Once the premium-paying period known as the accumulation phase is over, you stop paying the annuity and it will start paying you.

Your contract will now enter what is called the payout phase. During this phase, an annuity provides you with a guaranteed income for a set period of time. The amount you receive will be based mostly on how much money you put towards purchasing it. Generally, the more money you invest, the higher the return. 

To learn more, read our article on how you can get the most benefit from annuities

What are the main types of annuity? 

There are two main types of annuities that are offered in the market: fixed and variable. 

Fixed annuities 

In fixed annuities, the payout is a fixed sum and the annuitant will receive a principal amount and a minimum rate of interest. 

As long as the provider is financially sound, the money you invested in a fixed annuity will grow and will not decline in value. The growth rate of the annuity’s value and/or benefits you receive may be fixed at a specific amount or by an interest rate. It’s growth does not also depend directly or fully on the performance of investments the insurance company makes to fund the annuity. 

The convenience and predictability of a set payout makes a fixed annuity a popular option for retirees who want to have a steady income stream to supplement their other retirement income (e.g. super, Age Pension). 

The subcategories under a fixed annuity are equity-indexed annuity and market-value-adjusted annuity

An equity-indexed annuity is a type of fixed annuity, but has mixed features. It charges a minimum rate of interest, like fixed annuity, but its value is also based on the performance of a specific stock index. This is usually calculated as a percentage of that index’s total return.

Meanwhile, a market-value-adjusted annuity combines the two attractive features of giving the annuitant the ability to select and fix the time period and interest rate over which their annuity will grow and the flexibility to withdraw money from the annuity before the end of the set term. 

This flexibility is achieved by adjusting the annuity’s value to reflect the change in the interest rate “market” or the general level of interest rates from the beginning of the selected time period to the time of withdrawal of the money. 

Variable annuity 

The second main type of annuity is a variable annuity. The investment return and income paid by the variable annuity fluctuates with the performance of the underlying investments. 

However, in exchange for a fee, the provider of such products may guarantee a minimum payment, either for a set period or for life. The higher the amount of the guarantees, the higher the fees paid.

How and when do I receive my income from an annuity? 

When your contract enters its payout phase, payments can start immediately (immediate annuities) or at a future date you choose (known as deferred annuities). 

You will receive guaranteed income payments that can be given to you on a monthly, quarterly, half-yearly or yearly basis.

You can receive payments for a set period of time (fixed-term annuity) or for as long as you are alive (lifetime annuity). 

You also have the option to have regular payments fully or partially adjusted in line with inflation or not. Providing for inflation can substantially impact the cost of the annuity and/or the value of initial payments.

How can I buy an annuity?

Anyone aged 18 and above can buy an annuity. You can purchase one by using money from your regular savings or from your super.

However, if you are using super money to buy an annuity, you must have reached preservation age of between 55 and 60 or have met a condition of release outlined by the Australian Taxation Office (ATO).  

What happens if you die early after investing in an annuity? 

The Australian government’s MoneySmart website states that when buying an annuity, you will have two options to prepare for a scenario where you die after investing in an annuity. One is to nominate a reversionary beneficiary and the other is to select a guarantee period. 

A reversionary beneficiary is a person you have nominated (it can be your spouse or dependent) who will be receiving payments for the rest of their life, usually at a reduced amount of the income you were receiving from your annuity. 

With a guaranteed period option, your beneficiary gets your full payments, either as a lump sum or income stream (for a set period) after your death.

What are the advantages of an annuity?

  • Guaranteed fixed income regardless of how the sharemarkets perform.
  • Any payment you receive from an annuity you bought using your super money is tax-free from age 60.
  • Annuitant can choose for regular payments to reflect inflation.
  • No risk of outliving your payments (with a lifetime annuity).
  • Payments from certain annuities may give you beneficial Centrelink treatment.

What are the disadvantages of an annuity?

  • You will not receive the full amount of your annuity if you decide to withdraw your funds entirely and cancel your annuity (if allowed by provider).
  • Lack or no flexibility where your money will be invested. 
  • Low income payments if annuity payout period starts in a low interest rate environment.
  • Your money is illiquid; your money is locked away until the term or period of the annuity ends. 
  • You are not allowed to change the amount you receive once the payment period begins.

Can I lose money in an annuity?

Annuity products are generally described as “guaranteed”. But remember that the guarantee is as good as the provider. As with any financial product, the risk that your provider might go under should be taken into account when deciding. 

Additionally, remember to always read the fine print before you buy an annuity and make sure you understand the provider’s specific terms and conditions. 

Before deciding if an annuity is the right option for you, consider your personal needs and circumstances. You could also look into mixing your retirement options or consulting a licensed financial adviser to help you make a more informed decision.

What is an annuity and how does it work?
annuity retirement
nestegg logo

Forward this article to a friend. Follow us on Linkedin. Join us on Facebook. Find us on Twitter for the latest updates
Rate the article

more on this topic

more on this topic

More articles

Website Notifications

Get notifications in real-time for staying up to date with content that matters to you.