Lifetime Annuities and the quest for certainty
Lifetime annuities offer you the opportunity to outsource a large slice of the uncertainty associated with managing your retirement capital. You get to exchange your capital for an annuity that will offer you a guaranteed income stream for life. And, for an additional cost, this income stream can be indexed with inflation.
The growing demand for greater certainty since the Global Financial Crisis has brought lifetime annuities back to the forefront as a retirement solution. In this article, we ask whether they are a suitable alternative to the self managed solution that most retirees select by default?
The Uncertainties of Managing Retirement Capital
There are a number of risks to consider when managing retirement capital, including:
– Investment Risk – ensuring you get your capital returned and also receive the highest return you can for the risk you choose to take;
– Sequence Risk – two identical investors may generate the same average return over a period and experience different outcomes due to the order (or sequence) in which the returns appear;
– Longevity Risk – the risk that you may out live your investment capital. No one knows in advance when they will die which makes lifelong planning very difficult;
– Inflation Risk – the risk that your capital will progressively lose its purchasing power and be unable to fund an inflation adjusting income requirement;
– Tax Risk – the risk that tax will significantly reduce your spending power;
– Liquidity Risk – the risk that you run out of cash, despite potentially having plenty of (non-liquid) assets; and
– Expenditure Risk – the risk that you spend beyond (or too far within) your means.
Lifetime Annuities offer retirees the opportunity to outsource the first three of these risks to third party providers. You can also outsource the inflation risk by opting to receive the annuity payments as an inflation indexed income stream.
With the increasing desire of investors to reduce their risk exposures, lifetime (indexed) annuities are gaining traction in Australia and abroad. The critical question for investors is not whether these offerings will reduce your risk, but at what price they’ll reduce your risk.
In our view, minimising risk is a smart move provided you can afford to do so. With the asset price declines of the GFC, most investors are now in a position where they probably need to take more risk in order to support their objectives. Accordingly, for many, a low risk annuity approach may not be the best solution, despite the appeal.
The real advantage of the lifetime annuity product is the ability to outsource longevity risk. This comes at a price. The provider will embed a break even life expectancy into the annuity payment calculation. As a purchaser, you’ll win if you out live the break even age … and you’ll lose (or at least you’re beneficiaries will) if you die earlier.
You may expect the break even age to be around the life expectancy levels as quoted by the Australian Bureau of Statistics. A 65 year old male has a current life expectancy age of around 84. Yet, annuity providers will not use this age to calculate the annuity payments. They know that lifetime annuities are only appealing to those who expect to live a long time. Obviously, they don’t, for example, have the same appeal for someone who is terminally ill. Accordingly, the average life expectancy of annuity purchasers is much higher, meaning you may have to live longer than you think to outlive the break even age embedded in a lifetime annuity.
The presumption by many is that lifetime annuities offer society a great opportunity to outsource much of the financial risks faced by retirees. Unfortunately, these risks have to be borne by someone – the annuity provider.
Assessing the viability of a provider over a potential 35+ year period is pretty tough. While the providers have prudential requirements they have to meet (as overseen by APRA), you won’t know how they will invest the funds over time or what assumptions they’ve made with respect to the risks they have to manage. The worst case scenario would be to find that your provider under estimated the risks and was unable to meet its obligations to you.
The price you pay the provider to outsource these risks is a major consideration. The cheapest annuity is not necessarily the best. Yet to buy at any price is likely to be costly.
The price of annuities has a reasonable correlation to bond prices and will fluctuate. The timing of your purchase can be quite meaningful and should not be ignored. For example, over the last 6 months you could have paid up to 20% more for the same (indexed) annuity stream (from the same provider), depending on when you purchased the annuity.
Choosing a lifetime annuity provider is a lifetime decision
Lifetime annuities can offer a valuable alternative for individual investors seeking to transfer risk. However, because they bundle a number of risks into one product (e.g. investment, longevity and inflation) their value can be tough to assess.
The choice of provider and product is a much larger decision than other investment decisions, effectively because it’s a lifetime decision. While it’s possible to unwind a lifetime annuity (depending on the terms), it’s not likely to be an affordable option as the “break” costs are significant.
Despite their simplicity, lifetime annuities are far from simple to assess.
This article prompted a response from Stuart Barton, General Manager of annuity provider Challenger. TheBull has published the response below.
“As you may be aware, Challenger is the largest provider of term and lifetime annuities in Australia.
We respectfully disagree with a number of claims and conclusions made in the article published on thebull.com.au and would appreciate the opportunity to discuss them with you further, at a time convenient to you. Specifically:
1. The article infers that the recent popularity in annuities relates to lifetime annuities. While it’s true that annuities have experienced a strong resurgence since the GFC, it’s fixed term annuities which account for the vast bulk of new sales rather than lifetime annuities.
2. Regarding the positing of the strawman question “[are they] a suitable alternative to the self managed solution that most retirees select by default?”, its relevant to note that lifetime annuities aren’t marketed or recommended by advisors as an all or nothing proposition but as part of a retirement portfolio – principally to provide a reliable layer of income on top of any age pension entitlements, leaving remaining assets free to be invested in growth assets like equities. Even though they are the fastest growing market segment within the superannuation industry I’m also not sure that SMSFs could be accurately described yet as the default fund choice for most retirees.
3. Re the statement “As a purchaser, you’ll win if you out live the break even age … and you’ll lose (or at least you’re beneficiaries will) if you die earlier” and similar statements, this is a legacy misnomer which doesn’t reflect contemporary liquidity features as available with Challenger’s Liquid Lifetime annuity; ie, the ability to receive a full return of capital within the first 15 years of the policy. It was once a fair criticism of lifetime annuities but hasn’t been one for a few years now.
4. Re “A 65 year old male has a current life expectancy age of around 84. Yet, annuity providers will not use this age to calculate the annuity payments. They know that lifetime annuities are only appealing to those who expect to live a long time”. It is true that ‘adverse selection’ affects annuity pricing – but a greater influence is actually the mortality improvements that will occur during the retirement period which will push our true life expectancy even further. By the time the 65 year old male gets to 84 he’s actually likely to live to around 87, according to our actuaries.
5. Relevant to this is a point not covered in your article but which is highly relevant to retirement planning (and therefore somewhat conspicuous by its absence); the flaw in planning to average life expectancy. By definition this means that half the time a plan will fail because the client will live beyond the median.
6. Provider viability – “While the providers have prudential requirements they have to meet (as overseen by APRA), you won’t know how they will invest the funds over time or what assumptions they’ve made with respect to the risks they have to manage. The worst case scenario would be to find that your provider under estimated the risks and was unable to meet its obligations to you”. With respect, it’s hard to see this as more than scaremongering because it drastically understates the creditworthiness of the life companies which issue annuities and the relative transparency of their balance sheets. Under APRA’s new LAGIC regulatory capital requirements for life and general insurers, they must hold sufficient capital to survive 1:200 year adverse shocks. The GFC is widely regarded as a 1:70 year event. Because they mark to market the assets on their balance sheets, life companies are more transparent than those supporting your bank term deposit. What’s more, in Australia a life company issuing annuities has never failed to meet its obligations to policyholders. There isn’t a single managed fund nor super fund, particularly a self-managed one, that can claim to be more secure than an annuity – unless it’s invested solely in government guaranteed bank term deposits.
Wealth Foundations (ABN 36 121 535 993) (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369). The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.