Annuities were very popular in the 1980s when interest rates were high, as were the sales commission rates offered by insurance companies who marketed them. However, they fell into disrepute as people became aware of the lack of flexibility and the potential loss of capital.

Annuities are sort of reverse engineered insurance policies that provide an ongoing income stream in return for a lump sum capital investment. While there is merit in the concept of a reliable ongoing income stream, potential purchasers of annuities need to be aware that a major portion of the income provided is simply their capital being returned to them by instalment, plus an interest content.

Annuity payments are calculated by an actuary. Payments will depend on the amount of capital invested, the average interest rate over the term (fixed number of years or life expectancy) of the annuity , less the insurance company’s profit margin.

Investors considering an annuity ask the following questions prior to entering an annuity contract:

• What is the internal rate of return (or effective interest rate) being paid on capital invested?
• What is the access to capital (if any)?
• What is the term of the annuity e.g. lifetime or set period?
• What (if any) residual balance is available in the event of the death of the annuitant prior to the maturity date of the annuity contract?

In my experience, the answers to these questions may raise some serious concerns.

Annuities do not generally represent attractive earning rates. Therefore  care must be taken to avoid locking into a long-term contract at a low rate in the interest rate cycle. In my experience, a properly constructed conservative and balanced investment portfolio can sustain far more attractive earning rates over time.

Of particular importance is the question of access to capital. It is impossible to accurately predict what might happen to an individual in the future. Where an unforeseen change in personal circumstances requires access to capital, it may be greatly distressing to have capital tied up in a long-term annuity contract. This is particularly relevant now where self-funding of aged care facilities has become the norm.

As with all financial contracts, special care is required to ensure that you know and understand all the facts before signing a contract.

Any financial product advice provided is general in nature. It does not consider your needs, financial situation or objectives. You should consider the appropriateness of this advice to your circumstances before you act on it.