For investors looking for higher income from their fixed income investments, particularly those in the retirement phase, annuities may provide the answer
Here we look at the basics of what an annuity is, and what a fixed income annuity can offer.
What are you trying to achieve from your investments?
The question of asset allocation is key for retirees, and it is for this reason that we at FIIG have spent so much time over the last couple of years focusing on it for our clients both in The Wire and when speaking to them one-on-one. Since the onset of the GFC, markets, and equity markets in particular, have shown considerable volatility and while an investor with 20 or more years to retirement may be able to ride out such volatility, investors close to, or already in retirement do not have the same luxury of time to recover.
For investors who need to provide themselves with a regular income in retirement, these dips in equity markets (or cuts to share dividends), may cause them to eat into their capital base to fund their expenses, and for investors already in retirement, there are limited opportunities to rebuild their capital base.
For this reason, investors in retirement should be re-evaluating their asset allocation, with a focus on moving away from riskier, volatile markets like equities and property, and moving more of their allocation towards defensive, less volatile asset classes like fixed income.
A key driver of levels of allocation, and style of assets investors should hold is, “what are you trying to achieve from your investments in retirement?”
As a retiree, are you really looking for growth? What is really important to you at retirement age? Do you really want your portfolio to double over the next 20 years or do you want your portfolio to provide a steady income? For most retiree’s their investments must provide their “salary”, so this, the provision of salary, should be their key focus.
Paying yourself a salary
With continued volatility in equity and property returns and the increasing proportion of Australia’s population either in retirement or approaching retirement, investors have sought investments which provide more cashflow certainty so that they may pay themselves an income from their retirement savings.
At the same time, investors want to maximise the salary they are paying themselves. While fixed income investments by their nature provide a regular income, investors are still often looking for a higher salary. This has led to the re-emergence of a product once considered a little old fashioned, the annuity.
What is an annuity?
As annuities return regular cashflows they are usually classed as fixed interest investments. This is because on the surface, they are not unlike a fixed rate mortgage, where the annuity investor is the equivalent of the lending bank. The investor, in return for purchasing the annuity, receives a regular repayment that comprises an interest and principal repayment, until the principal balance is zero.
By repaying both interest and principal, an investor is able to receive an increased ‘salary’ from their investment, with the trade off being the repayment of the principal portion over time. For investors seeking a higher return, and who are less worried about re-investing the principal at maturity, an annuity may be a welcome addition to their fixed income portfolio.
Interest indexed annuities vs Retail annuities
While only life insurance companies can issue retail annuity products, some bond issuers issue interest indexed annuities (IIAs). These are effectively an amortising loan with the interest indexed to CPI. The regular interest repayments to investors are adjusted with reference to the inflation rate thus protecting the real value of the investors’ income payments over time.
IIAs will often provide returns superior to ‘retail annuity’ offerings as all of your investment return is returned to you, the IIA provider isn’t keeping significant amounts of your return to pay for advertising, administration, commissions, APRA capital standards etc. Whilst some retail annuity providers highlight their ‘no fee’ structure, in reality the actual returns they are paying are quite low, and you can be sure the returns they’re earning by investing your money is considerably higher, while there may be no ‘fee’, the provider definitely makes a profit.
By directly owning an IIA you also have the added flexibility of being able to exit your investment if something does happen and you need to access your money. IIAs can be sold quickly and without incurring any fees. Traditional annuities aren’t designed for people with emergencies, and if you wish to break the annuity and take some money out, you will be hit with a fee, if you are able to redeem the funds at all.
Who issues IIAs?
As most companies in Australia choose to issue ‘bullet’ loans (like an interest only loan) rather than amortising loans, IIAs tend to be somewhat scarce; however they are well suited to projects with definitive time lines.
We have previously covered a number of public-private partnerships including Praeco, the (Department of Defence Headquarters development) and Southbank (the Southbank Educational Precinct in Brisbane) and Royal Women’s Hospital, all of which exist for a pre-determined timeframe, and as such are well suited to the characteristics of an amortising debt profile. All of these PPPs offer IIAs in their funding structure and offer strong CPI linked returns.
For investors looking for a higher regular income with protection against inflation, we feel the IIAs with investment grade ratings, government backed revenue streams and low risk business profiles, offer a compelling investment opportunity.