Annuities should be an important part of a retirement income portfolio, so why don’t more Australian retirees have one?
As retirement income solutions go, annuities can be polarising. Sure, they are comparatively simple products that guarantee investors a low-risk income for either a fixed term or until death. However, many retirees find them confusing and are wary of locking their money away.
But that may be changing. As more and more baby boomers hit retirement age, insurance companies and financial experts are calling for incentives to encourage new market products and increase the appeal of these investments.
Although still a relatively small part of the overall retirement-income market, annuities have been growing in popularity, largely as a result of strong marketing and product development from Challenger, the dominant industry player in Australia.
“In the UK, underwriting is based on an investor’s postcode, which is seen as a proxy for longevity.”
“Modern annuities … are experiencing strong growth in terms of their demand,” says Richard Howes, the chief executive of Challenger Life. He puts this down to investors wanting solid products that make modest promises and meet them, especially since the global financial crisis.
Annuities involve investing a lump sum for a guaranteed monthly payment for a defined period. Such lifetime or fixed-term pensions can be bought from a life insurance company using superannuation or other savings. And as the income is fixed, and not tied to the ups and downs of the market, the investment is safe.
Many financial planners recommend annuities as part of a portfolio of investment products for retirees but some consumers have baulked at tying up their money in long-term annuities, particularly since interest rates have been so low.
Life insurance and SMSFs: Self-managed superannuation funds (SMSFs) provide a compelling opportunity for structuring members’ life insurance needs and determining the taxation benefits.
David Hasib, senior wealth planner at accounting firm Chan & Naylor, says while low interest rates are an issue, during the financial crisis annuities holders continued to receive regular payments, earning up to 7 per cent regardless of the market.
He says that education is important to dispel misconceptions about annuities, especially among some elderly clients who believe annuities die with them, even though provision can be made for payments to spouses or dependants to continue.
While annuities deserve their recent comeback, Hasib says they should be only one part of a portfolio of investments in retirement. They are not a silver bullet.
“Annuities play a part in that asset allocation. They can stabilise the portfolio with a known outcome and can play a very strong part in that defensive asset.”
During the GFC, some annuants continued to earn 7 per cent
Challenger’s research shows that more than half of all 65-year-old men currently in Australia are expected to live to age 88, while 10 per cent of women currently aged 65 are predicted to live to at least age 100.
While longer life expectancies are clearly welcome, this longevity presents a headache for both retirees and insurers as they seek to manage income streams and annuity products. The aim is to provide affordable annuities to retirees while enabling insurers to sell more policies at an efficient price and profit.
Michael Sherris, a professor of actuarial studies at the University of NSW (UNSW) Business School, has researched ways to build better annuity models. His studies show that the prices of annuities are based on a mortality table that assumes above-average longevity, making them too costly for many people.
The main problem is insurers’ standard assumption that all people aged 65 have the same chance of surviving to age 85 or 100. To address this problem, some insurers have started underwriting annuities to offer cheaper prices to those who are likely to die earlier.
In the UK, for example, underwriting is based on an investor’s postcode, which is seen as a proxy for longevity because of different wealth and health patterns from area to area. As Sherris explains, people in poorer socio-economic areas get a cheaper rate “because you’re in a group that’s probably not going to live as long as those in a certain London postcode that’s wealthy and drives BMWs”.
While Australian insurers do not currently engage in underwriting of this type, he says it could be likely if insurers extend annuities products to wholesale and industry superannuation funds.
“[Annuities] can stabilise the portfolio with a known outcome and can play a very strong part in that defensive asset.” David Hasib, Chan & Naylor
To ease the impact of low interest rates, some insurers are also offering annuities in riskier asset classes, such as equities, but they are imposing higher management fees.
“The insurer gives you a guarantee that even if the market tanks and you withdraw all your money, they’ll continue as long as you live to pay you a certain amount,” says Sherris, adding that overly generous guarantees such as this in Japan and the US have hurt some insurers.
Search for ‘game changers’
As retiree numbers mushroom, finding suitable income streams becomes more pressing. According to the latest research from financial services consulting firm Mercer, 54 per cent of Australians expect to have less money than they hope for in retirement, with the average shortfall likely to be almost A$500,000.
Dr David Knox, senior partner and senior actuary at Mercer, says there is no doubt that retirees have been cautious about committing their money in long-term annuities. While acknowledging that some people like the certainty annuities offer, he points out that lifetime annuities represent only about 1 per cent of all retirement dollars. “So they are not all that popular,” he says.
With a view to introducing innovative options, Mercer has released its “game-changing” solution. LifetimePlus is the world’s first pooled mortality investment fund, which will be part of an account-based pension within a customer’s superannuation account. LifetimePlus requires about half the amount of capital as an annuity to secure a similar annual income, according to Mercer, and it allows customers to access up to 95 per cent of capital up to the age of 75.
Knox says the product seeks to share longevity risk among members of super funds. If a person dies fairly early, a small proportion of their capital goes towards assisting those who live longer. The more people in the pool, the greater the stability.
“The real benefit is that when you’re in your eighties, you don’t have to live as frugally because you’re starting to see this extra income come in and boost your bank account,” explains Knox.
In Australia, regulatory restrictions on product innovation and provision have impeded the uptake of annuities. The recent financial system inquiry led by David Murray found some policies deterred people from taking up annuities and recommended a default “investments” option for retirees, or mandating the use of certain retirement income products, including annuities.
One of the key sticking points is that deferred lifetime annuities – those bought with an up-front single premium and through which regular income payments start after an agreed waiting period and continue for life – are not eligible for the concessional tax treatment that applies to investment earnings on superannuation assets.
Cathy Nance, a partner at PwC Australia and a spokesperson for the Actuaries Institute, says it is time for the Government to act on deferred annuities, despite election promises not to tinker with superannuation rules. “We need to change the market rules and let the market evolve,” she says. “The only thing stopping them is all the political machinations.”
Nance believes annuities are an ideal later-in-life product and, with an ageing population and superannuation balances set to grow, products such as deferred and pooled annuities will become even more crucial.
“Annuities will serve a bigger purpose for people as they get older and frailer and need a simple, more secure product.”
One condition Nance applies is that pooled annuities should be subject to regulatory oversight because once people sign up to them, they are very expensive to exit.
At Challenger, Howes says the other key recommendation from the financial services inquiry is the introduction of a comprehensive income product for retirement (CIPR), which would mean superannuation trustees pre-selecting such a product for members.
It would logically include some longevity protection and some account-based products.
Knox, at Mercer, endorses the CIPR initiative.
“We need to change the mindset. Super is not just about accumulating wealth, but about generating income for retirement.”
Data shows that annuities are finding flavour with financial planners
The way forward
Despite complexities in the market, new findings from wealth researcher Investment Trends indicate that significantly more financial planners are recommending annuities.
Its December 2014 Retirement Planner Report, based on a survey of 617 financial planners, reveals that 38 per cent of financial planners recommended annuities in 2014, up from 27 per cent in 2012. The intention to use annuities is also rising, with 59 per cent of planners intending to recommend annuity products in the coming year, up from 45 per cent in a previous study.
Howes is encouraged that more planners are endorsing the benefits of annuities. He says advisory models have evolved from simple risk-profiling of potential investors to factoring in more objective-based advice.
For instance, a planner may recommend allocating an aged pension for property payments, a private pension or lifetime annuity for basic living needs, and account-based products such as an allocated pension from superannuation for aspirational requirements.
“This shift in advice towards objective-based advice and the use of an income-layering approach has very much contributed to the wider adoption of annuities as an important part in an overall retirement-income portfolio,” he says.
Another key development, Howes says, has been the move by Colonial First State and Vic Super to make annuities available to retail customers. This means financial advisers will be able to combine account-based pensions with an annuity, delivering a more comprehensive retirement solution.
“Even if the market tanks they’ll continue as long as you live to pay you a certain amount.”
Michael Sherris, UNSW Business School
The good & bad of reverse mortgages
Reverse mortgages are part of the discussion about income streams for retirees. They allow pensioners and retirees to use the equity in their home as security for a loan.
That loan must be paid back in full, including interest and fees, when the home is sold, the owner dies or they move into aged care. With many older borrowers being asset-rich but cash-poor, it makes sense for them to be able to unlock capital in their homes to fund their lives. However, there are drawbacks: interest rates are usually higher than normal home loans; the debt can rise substantially as the interest compounds over the term of the loan, and the loan can affect pension eligibility.
Michael Sherris, of the UNSW Business School, says while reverse mortgages have great potential, the way they are priced at the moment is not attractive. He says such products have worked better in the US as a result of a government scheme that insures the mortgages. But private markets have struggled to make them viable.
Chan & Naylor’s David Hasib says the concept has merit provided the mortgages are structured and regulated correctly to prevent the adverse effects of compounding interest.
“If reverse mortgages are regulated in a manner that protects the consumer, I’d certainly be in favour of them,” he says.
Mercer’s David Knox agrees that reverse mortgages deserve consideration but says they need to be simplified. Another concern is that older borrowers who reach a negative equity threshold in their home may lose their financial incentive to maintain the property properly, resulting in a depreciation of its value.
“We need to change the market rules … The only thing stopping them is all the political machinations.” Cathy Nance, PwC Australia
Ageing at home: how Australia can cope with 1.2 million over 85s