Few people are likely to be interested in buying an expensive financial product which offers little return, particularly when that return is based on their life expectancy. But annuities, which provide a series of regular payments until the death of the annuitant in return for a lump sum investment, deserve closer attention.
Despite the benefits of annuitisation, there is considerable evidence of annuity aversion among individuals. This has led to what economists call the “annuity puzzle”. It’s like this: let’s agree there are some benefits, we won’t buy it anyway.
Life annuities provide longevity insurance, which is another way of saying they guarantee the annuitant an income until death. Managing longevity risk is an integral part of any retirement system. The recent Financial System Inquiry (FSI) regards longevity protection as a “major weakness” of Australia’s retirement income system.
The most popular retirement product, Account-Based Pensions (ABPs), provides flexibility and liquidity but leaves individuals with longevity, inflation and investment risks. The FSI recommends that superannuation trustees pre-select a comprehensive income product for retirement (CIPR) that has minimum features determined by the government. This product will help members receive a regular income and manage longevity risk. This is the main job of annuities.
One important feature of annuities is the return of capital (ROC). Investors are guaranteed up to 100% return of capital in the first 15 years of annuity purchase. If the investor dies in this period and does not have a joint owner or nominated person to receive payments when they die, a lump sum payment is made to her estate.
The idea of losing liquidity by locking up capital in annuities does not make the product very appealing. Also, the lower rate of return compared to investing directly in financial markets or alternative financial products is a reason why Australians shun annuities.
Annuitising is also seen as an irreversible choice in most cases and therefore investors are careful when to commit to it. This decision is delayed further when individuals have bequest or capital preservation needs, making full annuitisation an unlikely choice for most retirees. Today’s annuity with ROC to some extent caters for some of these concerns, but some of these drawbacks continue to loom large in the minds of investors.
Let’s consider deferred annuities instead. A deferred annuity is a financial security for which the annuitant makes a premium payment to the insurer. In return, the insurer agrees to make regular income payments to the insured for a period of time. However, unlike regular annuities, the first payment is deferred until an agreed future date, i.e. the deferred annuity does not make any payments until after the deferred period is passed.
They are cheaper compared to regular annuities, yet provide the necessary longevity insurance. Deferred Life Annuities (DLAs) continue payments until the death of the annuitant. DLAs have been acknowledged in 14 submissions to the Financial System Inquiry and received widespread support from industry bodies and associations encouraging its uptake. Legislative barriers, however, prevent the development of such a product in Australia.
The major risk to the annuitant purchasing deferred annuities is that she may not survive the deferred period, forfeiting her annuity premium. The Return on Capital concept could be employed to help overcome this. There is also a degree of counter-party risk involved since the life company might become insolvent before retirees’ income payouts begin.
What if we didn’t need life insurance companies to provide this longevity insurance? Could the big superannuation funds provide the income retirees need? They certainly could, by taking some lessons from the deferred annuities concept to build a Group Self-Deferred Annuity (GSDA). A certain percentage or amount of retiree’s wealth (depending on size of balance at retirement) goes to the superannuation fund’s “deferred investment pool” at retirement. This serves as premium for the deferred annuity. The retiree still holds liquidity and controls remaining wealth and has opportunity for higher consumption even before the annuity payments begin. Remaining wealth may be subject to account based pension regulations ensuring minimum drawdowns.
According to such a structure, the annuity begins to pay out at age 80 or 85 years and the retiree’s income level will be a function of the premium invested, investment performance and mortality assumptions. With this approach, superannuation funds would be able to provide the much needed longevity insurance without resorting to complex products outside of superannuation. The “deferred investment pool” would undoubtedly require meticulous management as it would serve retirees beyond the deferred age.
If the retiree died before reaching the income payment stage, a discounted amount of her premium may be returned to her estate. The upside to surviving the deferral period is that the retiree may receive high mortality credits; additional return above the risk-free rate of return on the annuity income. Mortality credits stem from the redistribution of pooled wealth among surviving participants from retirees who die in the payment period.
While we seek to have a comprehensive income product in retirement, there are several starting points. A Group Self-Deferred Annuity is one option.