Five things you didn’t know about annuities
Research
Lifetime annuities provide a simple solution for retirees seeking income for as long as they live. The annuity income is income for life. Historically, Australian retirees have not been large users of annuities, but this is not a sign that people don’t want a guaranteed income for life.
Surveys of what retirees want that don’t mention annuities by name repeatedly find that income for life is often strongly preferred. Sixty-seven per cent of respondents in a recent survey of over 3,000 super fund members thought that such a product would be appealing for their super.
The problem might be less about the appeal of the annuity itself and more to do with some common misunderstandings, but continuing innovation means that at least some of these fears can be relegated to history.
This paper considers the most common myths and highlight the 2020s reality for Australian retirees who want guaranteed income in retirement.
1. Death benefits - It can pay (your estate) to die early.
Myth: “I will lose everything if I die early”
A ‘traditional’ lifetime annuity is based on sharing the investment and longevity risk across a pool of people. Payments are conditional on being alive.
This created the concern that you could pay the initial premium, but only receive a limited number of payments before dying. While the original academic modelling assumed people knew the actuarially low risk of dying early in retirement, behavioural economics highlights that people overweight this fear. This reduces the appeal of a traditional annuity for many retirees.
The low actual risk of dying early in retirement provides for a relatively simple solution to the problem – a problem that Challenger addressed back in 2010 with the introduction of the death benefit, which provided a potential full refund of the initial premium in case of early death. The low risk, but disproportionate customer concern, means that providing a death benefit can provide insurance against the risk of early death and dramatically improve the overall appeal of the lifetime annuity to retirees.
Some policies have included a minimum payment period (of say 10 or 20 years) but a refund of the initial investment provides additional peace of mind. Now, instead of the risk of losing everything, early death means that your estate gets all of your initial capital. This is a very attractive feature, given that this is on top of all the payments made to you while you were alive.
The success of this in helping to revive the Australian lifetime annuity market prompted the Australian Government to incorporate the death benefit concept into retirement product regulations. The Capital Access Schedule of the Innovative Superannuation Income Stream reforms in 2019, enables a lifetime income stream to provide a 100% death benefit to the estate of anyone who dies within the first half of their ‘life expectancy’ (this ‘life expectancy’ is based on historical data and is lower than a retiree’s true life expectancy as it ignores mortality improvements over time).
For a typical retiree at age 67, the maximum death benefit will last 9-10 years. Beyond that, a smaller death benefit is payable on a reducing basis to life expectancy. A death benefit means that you and your family don’t lose if you die early, and it is now a standard feature of most lifetime annuities sold in Australia.
2. You can maintain market exposure
Myth: “Returns from annuities are always low”
As a guaranteed income stream, annuities have typically been based on investments in fixed-rate securities. The expected return on these investments is lower than the expected return on stock markets over the long run because they are a lot less risky, plus the annuity payments are guaranteed. Recent changes to superannuation rules allow a lifetime income stream to include exposure to equity markets. In these circumstances, the payments will be subject to fluctuations up or down but will importantly, will continue for life.
Products like this are now available in Australia with some super funds offering a lifetime income stream with a diversified underlying investment, including exposure to equity markets. Recently, Challenger launched a market-linked annuity that will make payments in line with one of five underlying diversified indices in the same way that a non-guaranteed, market-based income stream would rise (or fall). The market-linked annuity will make payments for as long as you are alive. The capital is pooled like a traditional annuity, but the payments are based on the underlying market returns from year-to-year, not just what can be guaranteed at the time of purchase.
3. Portfolio solutions - you should only annuitise what you need
Myth: “I would have to annuitise all my savings”
The seminal paper by Menahim Yaari demonstrated that under certain conditions, such as no bequest motive, it is economically rational for a retiree to annuitise all their wealth to maximise their income for life. Following this idea, it is often assumed that the only option is to annuitise all your savings. The OECD still does this in its methodology for comparing global pension systems. However, it doesn’t mean that retirees need to annuitise everything.
A traditional lifetime annuity pays an income stream that is guaranteed for life, sometimes with an in-built inflation adjustment. This is not how retirees typically spend over the course of their retirement. Spending is often higher in the earlier, active phase of retirement, and large expenditures can be lumpy. Most retirees don’t take an overseas trip every year (even when Covid wasn’t stopping them). There is a range of other spending that might be desirable but isn’t essential. In a pinch, this spending can be delayed or forgone if required. Such discretionary spending can be adjusted. Essential spending, on the other hand, happens every year.
It is also worth considering the Age Pension in Australia. As a safety-net, if a retiree runs out of money, they will receive payment from the government for the bare necessities. For many retirees, this won’t be enough (few people describe the Age Pension as comfortable living, especially in Australia’s major cities) but it means that retirees don’t need to put aside as much for essentials in a worst-case scenario.
This means a sensible retirement plan can have the best of both worlds. By investing part of their savings in a lifetime annuity, retirees can ensure that they will have all the income they need for as long as they live. They can maintain the majority of their savings in more flexible investments so they can spend it when they are best able to enjoy the benefits.
4. Annuity payments in Australia are protected by prudential supervision
Myth: “I don’t want everything invested in one place”
Annuities are more than just a corporate bond, even though fixed income securities will be the most common asset backing an annuity. When you invest in a corporate bond, you receive interest payments (coupons) that depend on the corporate entity being able to make the payments. Life companies that issue annuities are supervised by the Australian Prudential Regulation Authority (APRA), who require them to hold sufficient capital today to be able to make all payments to the annuity holder in the future.
This elevates the strength of the promise to an annuitant significantly beyond the contract a bondholder has with the corporate issuer. The margin of safety APRA requires to be provided by way of capital backing must be sufficient to meet a 1-in-200-year adverse market event. While future markets can go awry, APRA actively monitor life company investments with the aim of ensuring that the life company can meet the promises they have made to their customers both now and into the future. Challenger, like most life companies, holds significantly more capital than the regulatory minimum providing even greater security for annuity owners. It is possible for a life company to issue corporate debt, but annuity payments need to be made before the capital can be paid back to the bond holders.
5. Annuity payments are made up of more than just income
Myth: “My high return investments mean I’ll never run out of income”
The term ‘retirement income’ creates some confusion primarily due to the word ‘income’.
Annuity payments are retirement income but are more than just ‘income’ from investments. Annuity payments also include partial returns of capital, both from the initial investment and the survivorship bonus from the pooled structure. High investment returns are good, but you can also get exposure to these in an annuity (see myth 3).
For an investment to provide income that never runs out, you have to spend no more than the income produced. In general, spending very little is another way to ensure that the money lasts but that doesn’t maximise your retirement income and can unnecessarily impact your quality of life? To do this, you need to spend some of the capital. With any investment (that is not annuitised) spending the capital creates the risk of the money running out. Today, the benefits of a lifetime annuity should be attractive to many Australian retirees. Government reforms and ongoing product innovation have combined to provide better options and outcomes for retirees, overcoming the perceived flaws in the traditional product. Advisers have a clear role to play in guiding clients past some of these well-entrenched myths.