David Hasib Shares an Article
Previous generations saw retirement as being a few easy years of comfort after a life of hard work. In the 21st century, things are so different that we really need a new term for the period of life after full-time work. Now we’re not just living longer, but thanks to amazing medical and social advances, living better.
Many people don’t see retirement as an end, but a beginning – an opportunity to learn new things, visit new places, take up new activities and enjoy life to the full. It’s an exciting time. However with this new opportunity comes an age-old challenge. How are we going to pay for it?
The introduction of compulsory superannuation in 1992 has helped Australians save for their retirement but building up funds for retirement is only half the battle. Making those funds last throughout retirement is just as important.
Average life expectancy is increasing every year. Australian Bureau of Statistics* figures show that over the past 20 years, the number of people aged 100 years or over increased by 185% (compared to a total population growth of 30.9%). On this basis, if you’re 65 today, there’s a good chance you’ll live well into your 90s, so the decisions you make about investing your retirement funds are critical for ensuring your money lives as long as you do.
Share market risk
Over the long term shares have delivered considerable growth. The Australian share market experienced a bull market through most of the past two decades, with particularly strong performance between 2003 and 2007.
Buoyed by these strong growth prospects, Australians have increasingly invested in shares, particularly as part of superannuation. In 2009, our super funds still had the highest exposure to shares amongst all OECD countries.*
Many Australian investors had become so accustomed to shares going up they lost sight of the risks involved. However, when the global financial crisis (GFC) hit in 2008, and our share market plunged, 26.7% was wiped off the total value of Australian superannuation funds, wreaking havoc for many retirees. Investing in shares is not for the faint hearted. As demonstrated by the GFC, shares can be extremely volatile over short periods and take a long time to recover.
Growing assets versus protecting assets
During our working lives, when we’re building up our superannuation, most people can afford to take some risks in order to maximise gains over the long term. For example, if you want to retire in 20 years or more and you do not need access to your super, you can probably weather a market correction.
However, for retirees who require a regular income from their superannuation funds, exposure to market corrections can have a very adverse impact. During 2008 and 2009, as a result of the GFC, retirees who were heavily invested in shares were forced to sell down their holdings to fund their basic income requirements. Then, by eating into their capital, these investors had a smaller base from which to generate growth when the market recovered. This is the key difference between investing during your working life and investing during retirement; once you start depleting your capital to fund your living expenses, your ability to recover losses is severely diminished. As people reach retirement, protecting their assets and preserving their savings become much more important.
What is an annuity?
An annuity is a simple, secure financial product that guarantees a series of payments, for a fixed term or for life, in return for an upfront investment. The capital can be returned at the end of the agreed term or gradually during the term of the annuity in the form of income payments.
The rate of return is fixed at the outset, and this applies for the length of the annuity, regardless of share market movements or interest rate fluctuations. Annuities provide the comfort of a pre-agreed, guaranteed income stream for a specific period of time or for life.
Annuities can only be issued by life insurance companies. In Australia they are strictly regulated by the Australian Prudential Regulation Authority (APRA), which also oversees our banks and superannuation funds.
Annuities are extremely popular, with $9.5 billion invested in Australian annuities as at 30 September 2010 according to Plan for Life Actuaries and Researchers.
Features of an annuity
Annuities have a number of features that can be tailored to suit different needs. The main features are as follows:
Term – ‘Term’ refers to the length of an annuity policy. Fixed term annuities are generally available for fixed terms of between one and 50 years. The investor selects the term most appropriate to them. The term of a lifetime annuity is the rest of the investor’s life – income payments continue until they die.
Earnings rates – The earnings rate (or rate) refers to the interest paid by a fixed term annuity. For example, an investor taking out a $100,000 three year annuity, offering a rate of 6.46% p.a. and annual income payments, would receive interest of $6,460 each year*.
The earnings rate provided at the time of the investment applies for the term of the annuity.
Payments can generally be made monthly, quarterly, half-yearly or annually. The amount of income paid can be fixed at the outset, indexed by a set percentage or indexed to inflation. For a lifetime annuity payments must be indexed to inflation. Indexing against the impact of inflation may be particularly relevant for long-term annuities as it provides protection against increases to the cost of living.
Residual capital value (RCV) – Any capital left at the end of an annuity term is known as ‘residual capital value’. The residual capital value, or RCV, is usually set by the investor at the start of the annuity.
It can be 100% of the capital invested, 0% of the capital, or generally somewhere in between. If an RCV of 50 is set, then 50% of the initial capital is paid out through income payments and 50% is repaid to the investor at the end of the term.
In the case of a 100% RCV annuity (also known as RCV100), income payments are made up entirely of interest earned on the investment. The initial investment amount is preserved and paid back to the investor when the term of the annuity ends.
At the other end of the spectrum, income payments for a 0% RCV annuity (also known as RCV0) include interest earned on the investment and a portion of the original capital invested. There is no capital left at the end of the investment.
Benefits and risks:
- Guaranteed income and capital
- No management fees
- Regular, dependable income
- Attractive returns
- Flexible terms and payments
- Inflation protection
- Tax effectiveness – If you are over 60 and invest in an annuity using superannuation monies, payments from the annuity are tax free.
As with all investments annuities carry some risks. These risks include the risk of locking up your money for an extended period of time, potentially receiving less back than the amount originally invested if you terminate the annuity early, possibly affecting your social security benefits, inflation risk and the risk that the provider is not able to meet the payments under the annuity when they are due.
Director of Chan & Naylor Financial Planning
For more information regarding Annuities or how it may assist your portfolio, please call:
Chan & Naylor Financial Planning on 1300 99 77 34 or visit www.chan-naylor.com.au
About the guarantee’.
* Based on the rate of a RCV100 Challenger Guaranteed Annuity as at 28 February 2011. Article contributed by Challenger.
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