How Annuities Work

The global financial crisis left many self-funded retirees and investors scratching their heads.  Share prices and company dividends plummeted, property prices went into free-fall, and the collapse of banks and other financial institutions left many investors wondering where all their hard earned savings had gone.

Those investors with diversified portfolios and longer term investment horizons were not as concerned.  We’ve all heard the saying about not putting all your eggs in one basket.  Higher risk generally means higher returns; however, the global financial crisis realised the associated risk of higher potential losses that goes with achieving these higher returns.  Many investors are now reassessing their risk profiles and seeking safer havens for their money.

One such investment vehicle is an annuity.

An annuity is basically an agreement to receive a specified sum each month (or quarter or year) in exchange for a lump sum invested.  Annuities can vary in term from 1 to 25 years and there are even annuities with a lifetime payment option, meaning exactly that – you will receive this payment for the rest of your life.  Naturally, this is effectively a calculated gamble on how long you are likely to live.  Having a stack of centenarians in your family tree is no guarantee that you are going to follow suit and therefore receive some free money by living beyond the portfolio break-even point calculated by the issuer’s actuaries.

Annuities are usually guaranteed by the issuer; however, in the wake of the global financial crisis, any guarantees are regarded with a healthy dose of skepticism.  They are certainly not the gilt-edged 100% rock-solid guarantee of the past and you need to satisfy yourself about the financial strength of the issuer.  Remember the risk vs return equation and consider your attitude to risk when comparing annuity options. 

You also need to be aware that, unlike simple cash investments, annuities usually involve capital depletion.  They are able to offer higher periodical returns because part of that return is the capital you invested at the outset.  This will be set out in the annuity agreement, together with the management and any other fees payable by the investor, whether and by how much the annuity will grow with inflation (known as indexation), and whether there will be a capital value at the end of the term of the annuity.  Defined benefit annuities over a specific term will generally have one, while lifetime annuities will not.

As with all investments, read the fine print.  If something sounds too good to be true, there is a fair chance that it is too good to be true.  Ask lots of questions and it is a good idea to involve your accountant or financial adviser and probably have your lawyer go over the fine print before handing over your funds.  Be wary also of investing in an annuity with a specific institution on somebody’s recommendation as they may be receiving a commission for their recommendation and not have your best interests at heart. 

That said, annuities can play an important role in an investment portfolio.  Having a diverse range of income sources is particularly important in retirement and an annuity may be just the right component to add to provide a relatively secure (but not foolproof) and regular income stream to your investment portfolio.