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Updated: Aug 9, 2023

The term ‘Annuity’ is often mentioned in the financial press, but what actually are annuities and how do they work in practice?

The word annuity itself originates from the meaning ‘annual’ and can by definition, be described as ‘a yearly allowance’. To explain them in plain English is as a ‘really long term deposit, one where it is known exactly what the interest rate will be all the way along and when the payments will stop’.

what is an annuity

Although many people may immediately think an annuity is locked away forever, that’s not always necessarily true. Like a term deposit an annuity can actually be cashed in before the term expires (even the lifetime ones in some cases). This may not always be the best course of action but don’t immediately disregard annuities if this is your main concern.

So, why have an annuity within a portfolio? If you have read this far, stay with us as they do make a lot of sense when used appropriately.

Annuities play an important role in cash flow management, and can provide much needed certainty when stock markets are volatile and it seems like the rest of the portfolio is heading south.

They can also be used for different terms - from one year up to the day when we meet our Maker. Annuities can be set up to pay 100% of the amount invested back when the term is over, or just some of it (if that meets a specific objective).

Let’s look at a simple example

Vicky is 62, retired, and knows she needs $35,000 to meet her annual income requirements. What she also knows is of that amount, $10,000 is enough for her basic ‘fixed’ costs - all the main bills, etc. The rest is her ‘lifestyle’ money. Her financial adviser recommends that she purchase an annuity to pay for these fixed costs.

The income is fixed, and (like the bills) can be indexed to inflation. Vicky will then have the certainty that over her lifetime the annuity will always be there to pay the bills she has to pay - no matter what investment markets do, or even what the politicians decide to change. Her other everyday costs are covered by her pensions: the Age Pension and Account Based Pension from her super. All have a purpose and provide her with peace of mind, but perhaps none more so than the annuity. Saying that, the annuity is not going to grow 20% in value in any given year, but that’s not what it’s designed to do (it’s also not going to drop 20% either!).

What about SMSFs?

Annuities can also be used in Self-Managed Super Funds. A strategy here can be to set aside say three years of annual pension payments, while the rest of the portfolio provides the growth component.

Vicky’s case study illustrates a very simple concept. There are however many ways to use an annuity in a financial plan - too many to go into detail here. The tax and Centrelink treatment is also complicated, but if the idea behind an annuity appeals to you contact your licensed financial adviser to find out how one might fit into your retirement income strategy.

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