Note: In this article, Sean Corbett, an annuities expert and a SuperGuide guest contributor, answers the important question of when is the right time to purchase a deferred lifetime annuity. Separately, Sean has also written an excellent article comparing different retirement options, and under what circumstances such products would be most beneficial for retirees. He also explains the role that deferred lifetime annuities can play in reducing longevity risk, while protecting income and still leaving some money for the kids and grandkids (see SuperGuide articles Guest contributor: Reducing the risk of outliving your retirement savings and also background article Deferred lifetime annuities: Why does the Government want you to use them?). The link to these two articles also appear at the end of the article you are now reading.
Since 1 July 2017, the government has extended the tax exemption on earnings in the retirement phase (currently applicable to superannuation pensions) to other retirement products, such as deferred lifetime annuities and in-house annuity products that super funds, or other financial organisations, may want to offer.
Is there an optimal time (during retirement) at which a deferred annuity should be purchased?
The short answer is as soon as possible. There are three main reasons for this.
Firstly, the earlier that people invest prior to payments commencing means that the period until income payments starts (called the deferral period) is longer. A longer deferral period means that the money available to pay an income to those who survive will have longer to grow through compounding earnings and will therefore be a larger amount at the time that payments commence. More money means that the payments can be higher.
Secondly, a longer deferral period means that the number of people who will receive an income (ie. the proportion of survivors) will decrease more. Less people to pay means that the payments can be higher.
Thirdly, assuming the pricing by providers of deferred annuities accords with the theory of the way that they should be priced, a longer deferral period means that the assumed earning rate built into the pricing of the deferred annuity should be higher.
The reason for this is that the provider should be able to invest in riskier assets because they would be more able to avoid losses that are occasionally experienced by riskier assets. Also, they would be able to maintain their investment in riskier assets for longer before switching to safer assets as the commencement of income payments approaches.
If you look at the case of the All Ordinaries Accumulation Index (the index of the Australian share market assuming reinvestment of dividends) you will find that it has experienced losses in real terms (i.e. after allowing for inflation) at the following rates over various rolling periods since the start of 1980 until March this year.
| Timeframe | Probability of loss over period |
|---|---|
| Rolling 1-year periods | 27.52% |
| Rolling 2-year periods | 25.00% |
| Rolling 3-year periods | 20.63% |
| Rolling 4-year periods | 15.00% |
| Rolling 5-year periods | 8.25% |
| Rolling 10-year periods | 0.00% |
The chance of losses being experienced reduces the longer the period. Therefore, the longer the deferral period, the more likely the provider is to invest in riskier assets which earn a higher return.
Also, because they are required to sell assets to fund income payments, providers would be more likely to switch to less risky assets that are less likely to experience a loss once payments start to avoid losses being crystallised when assets are sold. The longer the deferral period relative to the payment period means that the pricing of the annuity on average across the whole period should assume a higher earning rate.
If the deferral period, when riskier assets that earn higher returns are invested in, is only 10 years and the payment period, when less risky assets that earn lower returns are invested in, is 30 years the average earning rate across the whole period will be lower than in the case of a deferral period of 20 years and a payment period of 20 years.
Deferred annuities: How long should the deferral period be?
I will now consider a related question, which is how long the deferral period should be for.
Deferred annuities do not have to start paying an income at your life expectancy. Deferred annuities can actually start to pay an income before or after you reach your life expectancy. Let us have a look at the results for various deferral periods based on the assumptions that were used in the original article (see SuperGuide article Guest contributor: Reducing the risk of outliving your retirement savings), including that no earnings are assumed for the sake of simplicity, for someone with retirement savings of $100,000.
Note that the figures in the table below have been rounded.
| Deferral period of 5 years | Deferral period of 10 years | Deferral period of 15 years | Deferral period of 20 years | Deferral period of 25 years | |
|---|---|---|---|---|---|
| Annuity investment | $75,000 | $53,000 | $34,000 | $20,000 | $10,000 |
| Income per year | $4,900 | $4,700 | $4,400 | $4,000 | $3,600 |
| % Who leave bequest | 12.5% | 25% | 37.5% | 50% | 62.5% |
| Average total income | $98,000 | $94,000 | $88,000 | $80,000 | $72,000 |
| Average bequest | $2,000 | $6,000 | $12,000 | $20,000 | $28,000 |
| Maximum bequest | $25,000 | $47,000 | $66,000 | $80,000 | $90,000 |
| Average gain | $0 | $0 | $0 | $0 | $0 |
| Maximum gain | $97,000 | $88,000 | $75,000 | $60,000 | $44,000 |
| Maximum loss | $75,000 | $53,000 | $34,000 | $20,000 | $10,000 |
As you can see, as the deferral period gets shorter (see 5-year deferral period) the amount of income that can be received increases while the amount that is required to purchase the annuity also increases. At the same time the average bequest and maximum bequest reduces, while the maximum gain and maximum loss both increase. The reverse happens as the deferral period gets longer.
If you opt for a longer deferral period (see 25-year deferral period) the amount of income that can be received decreases while the amount that is required to purchase the annuity also decreases. At the same time the average bequest and maximum bequest increases, while the maximum gain and maximum loss both decrease.
As with the conclusion in the original article (see SuperGuide article Guest contributor: Reducing the risk of outliving your retirement savings), the best approach for you will depend on what is important to you, and your particular needs. You should select a deferral period that best balances what you want in terms of income, bequests and losses upon early death.
For more information…
For more information about annuities and deferred annuities, see the following SuperGuide articles:
- Peace of mind, at a cost: 10 things to know about annuities
- Deferred lifetime annuities: Why does the Government want you to use them?
- Guest contributor: Reducing the risk of outliving your retirement savings
- Life expectancy: Will you outlive your retirement savings?
Contributor Sean Corbett has worked in the superannuation industry for 25 years, principally in the areas of product management and product development. He has worked at Connelly Temple, Challenger, Colonial Life and Oasis Asset Management where he specialised in annuities. Sean holds a Bachelor of Commerce from Queensland University and also holds an undergraduate degree with honours in economics and a masters degree from Cambridge University.
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