Longevity risk: How deferred annuities can help your savings last

Sustained earnings on your savings will increase the period of time a set amount of income can be received for, or the size of the income that can be received, or both, but do not fundamentally change the relationship between the amount of savings you retire with, how much income you can receive each year and how long your income will last for, so we will ignore earnings in this article to make the fundamental lessons clearer.

Scenarios

We will consider 4 different scenarios that cover the approaches that a person can take in retirement.

1. Individual funding for life expectancy (enjoying higher income but high risk of running out of income)
2. Individual funding for life (sacrificing income to counter the risk of running out of income)
3. Group funding for life through an immediate lifetime annuity (guaranteeing income at the risk of losing your capital if you die early)
4. A combination of individual funding for life expectancy and group funding from life expectancy through a deferred lifetime annuity (sacrificing some income to remove the risk of running out of income while protecting most of your capital against the risk of loss if you die early)

1. Individual funding for life expectancy

Where do you start when trying to decide how much income to draw from your savings in retirement at the same time as making sure they last as long as you do?

This is difficult because how long your savings need to last for is a mystery for every individual because no one knows how long they will live for. One approach is to set your income at a level that means your savings will last for how long you will live for on average, which is called your life expectancy.

A person with $100,000 in savings who funds their retirement individually can receive $5,000 a year for up to their life expectancy of 20 years. Note that we have ignored earnings for the reasons noted above in the assumptions, as we have for all of the 4 scenarios.

The average total income for people who take this approach will be $75,000. This average comes about because the 50% of people who die in the first 20 years will receive total income of between $0 and $100,000, giving an average of $50,000 for them. The 50% of people who die in the second 20 years will have received total income of $100,000, giving an average of $100,000 for them. The average across the whole group will be $25,000 (an average of $50,000 for 50%) plus $50,000 (an average of $100,000 for 50%), giving a total average of $75,000.

The average bequest (that is, any remaining capital a person can leave to beneficiaries) for people who take this approach will be $25,000. This average comes about because the 50% of people who die in the first 20 years will leave a bequest of between $100,000 and $0, giving an average of $50,000 for them. The 50% of people who die in the second 20 years will leave no bequest. The average across the whole group will be $25,000 (an average of $50,000 for 50%) plus $0 (an average of $0 for 50%), giving a total average of $25,000.

There are no gains or losses on death as any amount not received as income can be left as a bequest to chosen dependants.

Consequence: Obviously there is a problem for those who live for longer than 20 years, which will be half of all people. These people will have no income after reaching their life expectancy of 20 years (if you retire at 65, this means that your income will run out at 85).

How can this problem be dealt with if we are investing as individuals?

2. Individual funding for life

The only way to deal with the problem of outliving your savings when we invest as individuals is to lower the income we receive to make our money last for the entire period for which we might remain alive. This means we must reduce our income to make it last for the maximum period we will be alive, which is 40 years under the assumptions we are using.

A person with $100,000 in savings who funds their retirement individually can receive $2,500 a year for life.

The average total income for people who take this approach will be $50,000. This average comes about because the 50% of people who die in the first 20 years will receive total income of between $0 and $50,000, giving an average of $25,000 for them. The 50% of people who die in the second 20 years will receive total income of between $50,000 and $100,000, giving an average of $75,000 for them. The average across the whole group will be $12,500 (an average of $25,000 for 50%) plus $37,500 (an average of $75,000 for 50%), giving a total average of $50,000.

The average bequest for people who take this approach will be $50,000. This average comes about because the 50% of people who die in the first 20 years will leave a bequest of between $100,000 and $50,000, giving an average of $75,000 for them. The 50% of people who die in the second 20 years will leave a bequest of between $50,000 and $0, giving an average of $25,000 for them. The average across the whole group will be $37,500 (an average of $75,000 for 50%) plus $12,500 (an average of $250,000 for 50%), giving a total average of $50,000.

There are no gains or losses on death as any amount not received as income can be left as a bequest to chosen dependants.

Consequence: Halving income but receiving it over a 40-year period has solved the problem of people living for longer than their income. However, it has been replaced by the problem of people having their income halved to eliminate the potential of experiencing a shortfall.

Another problem with this approach is that, if you are providing your retirement income from your super savings (which most people do) and you do this through an allocated pension (which is the product used by the majority of people), the minimum withdrawal requirements mean that your income will not be able to be set sufficiently low to make it last for life but you are required to set it at a level that means it will run out at life expectancy.

The minimum withdrawal is set at 5% of savings for a 65 year old. So if you commence your income at the minimum level and maintain your income over retirement your savings will only last for your life expectancy.

This was intentionally done when allocated pensions were originally allowed for under the rules governing super. The minimums were designed to ensure that withdrawals were maintained at a level that would mean the allocated pension would only last for life expectancy. This was done to ensure that people did not use allocated pensions to indefinitely hide their savings in the tax-free environment that applies to super savings in retirement.

Is there another way we can deal with the problem of having to drastically reduce our income to make sure it lasts for life? There is, but to access it we need to stop investing as individuals.

3. Group funding for life through an immediate lifetime annuity

As with many other risks, insurance products have been developed to allow people to offset the risk of outliving their savings. These products do this by spreading the risk among a group of people so as to make it manageable for each individual who takes the insurance.

Lifetime annuities are insurance products that address the risk of running out of money in retirement by living longer than your money lasts. This risk is called longevity risk. The way in which a lifetime annuity gets around the problem of longevity risk is by pooling the money of the people who invest in them and using the remaining money from those who live for less than the average (ie. life expectancy) to pay an income to those who live for longer than the average.

Let us look again at our example.

With a lifetime annuity, the investment amounts of the group are pooled and the remaining money of those who die before 20 years is used to provide an income for those who live for longer than 20 years. Thus, the $100,000 of remaining funds from someone who died at the start of the period (20 years less than the average) would be used to provide 20 years of income for someone who dies at the end of the 40-year period (20 years longer than the average). Similarly, the $5,000 remaining from someone who lives for only 19 years (one year less than the average) is used to provide an income for someone who lives for 21 years (one year longer than the average).

If individuals fund their retirement as a group through a lifetime annuity, people can receive $5,000 a year for up to 40 years, which is the maximum they will live for.

The average total income across a group of people who take this approach will be $100,000. This average comes about because the 50% of people who die in the first 20 years will receive total income of between $0 and $100,000, giving an average of $50,000 for them. The 50% of people who die in the second 20 years will receive total income of between $100,000 and $200,000, giving an average of $150,000 for them. The average across the whole group will be $25,000 (an average of $50,000 for 50%) plus $75,000 (an average of $150,000 for 50%), giving a total average of $100,000.

The average bequest for people who take this approach will be $0 because any remaining funds from those who die early are used to pay an income to those who live for longer.

There are gains or losses on death as any amount not received as income cannot be left as a bequest.

A person who dies at the start of the period will have invested $100,000 and received no income, leading to a loss of $100,000. A person who dies at the end of the period will have invested $100,000 and received $200,000 of income, leading to a gain of $100,000.

Consequence: Even though individuals are as likely to experience a gain as experience a loss (because they do not know how long they will live for and because deaths are spread over the period), and on average there is no gain or loss, individual people will experience losses and gains and the maximum loss is high. There is also no scope to leave bequests.

How can we deal with the potential for high individual capital losses and the inability to leave a bequest if we are investing as a group?

4. A combination of individual funding to life expectancy and group funding through a deferred lifetime annuity

As mentioned above, there is a potential high capital loss for individuals if we invest as a group in an immediate lifetime annuity. This consequence arises because, although on average there are no gains or losses upon death across the group, there are individual winners and losers depending upon how long individual people actually live for and this can lead to people viewing immediate lifetime annuities as penalising them unduly if they die early.

Recent changes to the regulations by the government in Australia have allowed the development of new types of lifetime annuities, called deferred lifetime annuities, that can help address this potential loss of capital.

The way in which deferred lifetime annuities do this is by lowering the amount that needs to be invested in the annuity, thereby lowering the maximum loss. The amount that needs to be invested in the lifetime annuity can be lowered by deferring the commencement of the lifetime annuity into the future, leaving the remainder of the person’s funds to cover the period until the lifetime annuity commences to provide income.

Such an approach makes sense when you consider the risks involved. Essentially the risk we are insuring against is the risk of outliving our income. In our example, in the first scenario, where people invest individually, there is no risk of running out money for the first 20 years of retirement, after which the risk is 100%.

What if we were to only insure to cover the period when the risk exists? This is what deferred lifetime annuities do.

Let us look again at our example. If an individual funds the first 20 years of their retirement individually and funds the second 20 years by investing as a group through a deferred lifetime annuity (when the risk of running out of money actually exists), people can receive $4,000 a year for life and reduce their potential maximum loss.

They will slightly reduce annual income but minimise capital loss by investing $80,000 for the first 20 years, which will provide them with $4,000 a year (80% of the $5,000 a year that $100,000 will provide), and investing $20,000 in a deferred lifetime annuity (DLA) that will provide them with $4,000 a year from 20 years until no one is left alive.

Just like an immediate lifetime annuity, a DLA also uses the remaining money of those who die earlier to provide an income to those who die later. But a DLA only needs to do this for half the number of people (only half will survive beyond 20 years) and the DLA only needs to do it for half the amount of time (20 years rather than 40 years).

If  $100,000 is invested in an immediate lifetime annuity it can provide $5,000 a year for up to 40 years. In comparison, a DLA only needs to provide an income for half of the people (doubling the income it can provide from $5,000 to $10,000) for half of the time (doubling the income it can provide again, from $10,000 to $20,000) –  $100,000 invested in a deferred lifetime annuity could provide $20,000 a year.

As a result,  $20,000 invested in a deferred lifetime annuity will provide $4,000 a year from 20 years for life (20% of the $20,000 a year that $100,000 will provide).

The average total income for people who take this approach will be $80,000. This average comes about because the 50% of people who die in the first 20 years will receive total income of between $0 and $80,000, giving an average of $40,000 for them. The 50% of people who die in the second 20 years will receive total income of between $80,000 and $160,000, giving an average of $120,000 for them. The average across the whole group will be $20,000 (an average of $40,000 for 50%) plus $60,000 (an average of $120,000 for 50%), giving a total average of $80,000.

The average bequest for people who take this approach will be $20,000. This average comes about because the 50% of people who die in the first 20 years will leave a bequest of between $80,000 and $0, giving an average of $40,000 for them. The 50% of people who die in the second 20 years will leave no bequest. The average across the whole group will be $20,000 (an average of $40,000 for 50%) plus $0 (an average of $0 for 50%), giving a total average of $20,000.

As with an immediate lifetime annuity, while there are no gains or losses on average across the group, there is a range of gains and losses for each individual because any amount invested in the DLA that is not received as income cannot be left as a bequest. But, because the amount invested to cover the risk of outliving your income is greatly reduced, the potential gains and losses are reduced and losses are reduced much more than gains.

A person who dies at the start of the period will have invested $20,000 and received no income from the DLA, leading to a loss of $20,000. A person who dies at the end of the period will have invested $20,000 and received $80,000 of income from the DLA, leading to a gain of $60,000.

Consequence: DLAs allow people to cover the risk of outliving their income without having to drastically reduce their level of income and also allow them to leave most of their remaining money as a bequest if they die early. They also greatly reduce the maximum loss that an individual can potentially experience.

Income summary of the 4 scenarios

A summary of the key figures under the 4 scenarios showing how much income people will receive, how much they will be able to leave as a bequest and how much of a shortfall in income they will face for the different situations are as follows.

If people choose to invest as individuals, with a $100,000 savings balance (and using assumptions mentioned at the start of the article), they can provide themselves with $5,000 a year of income for 20 years, which is, on average, how long they will live for in our example. On average they will receive $75,000 as income and leave a bequest of $25,000. The problem with taking this approach is that 50% of people will outlive their income.

To address this consequence while still choosing to invest as individuals, the only option is to reduce their income to $2,500 a year for life. On average they will receive $50,000 as income and leave a bequest of $50,000. The problem with this approach is that their income is reduced by 50%.

Until now the alternative way to address the consequence of outliving your income was to invest as a group in an immediate lifetime annuity. These allow people to provide themselves with $5,000 a year of income for life. On average they will receive $100,000 as income. The consequences of this approach is that they will leave no bequest and the maximum loss is $100,000.

A newly available alternative that addresses the adverse consequences arising from the immediate approach to group funding is for people to invest some of their money as a group to provide a deferred income from the 20-year mark. This approach (Scenario 4) allows them to provide themselves with $4,000 a year for life. On average they will receive $80,000 as income and leave a bequest of $20,000.

If we take as our benchmark, Scenario 1 (a person investing individually to maximise income over 20 years), the scenario where people invest in a DLA (Scenario 4) results in average total income decreasing by 20% and the number of people who outlive their income falling from 50% to 0%.

Using a DLA achieves this result by avoiding the 50% fall in income required under the scenario where a person invests individually for life (Scenario 2) and also reduces the potential for loss of capital under the scenario where a person invests in an immediate lifetime annuity (Scenario 3) from 100% to 20%.

Bequests versus Income

It is worth noting that any amount that is not used to provide an income (that is, any amount used to provide a bequest) will result in the amount of total income falling. This can be seen in all scenarios. The average amount that is left as a bequest matches the amount by which average total income over the period falls short of the amount available to invest.

Risk summary of the 4 scenarios

Lifetime annuities not only remove the risk of outliving your income, they can also reduce or remove other risks.

Investment returns tend to be positive and relatively stable over the long term, especially real returns, which are the returns earned after allowing for inflation. This is because markets over the long term tend to set prices such that earnings are positive and above inflation. Otherwise investors would not invest.

This is not to say that markets cannot be mispriced and lead to losses in the shorter term, so investment risk is something that needs to be considered, particularly for people who invest individually and who are not investment professionals. Also, inflation risk, particularly over the longer term, may be low but is never nil for individual investors.

The income from lifetime annuities in Australia is required to be guaranteed, meaning the returns of the investments backing them are guaranteed so that investors do not face investment risk. Lifetime annuities also protect against inflation risk because you can choose to have your payments indexed to keep up with inflation.

There are three other risks we will consider:

• Lifestyle risk. This relates to the level of income that is provided under each scenario. A low income or no income places your lifestyle at risk.
• Bequest risk. The risk to your ability to leave a bequest on death.
• Loss risk. The risk to you of a loss of capital that is not returned as income.

A summary of the risks in each of the scenarios is provided below (assuming any lifetime annuities are indexed to provide inflation protection).

Scenario 1: Individual Funding for Life Expectancy

This scenario carries three areas of high risk. There is a high risk of outliving your income. There is also a high lifestyle risk and a high bequest risk because people who live for longer than average will have no income and no assets to leave as a bequest after 20 years.

Scenario 2: Individual Funding for Life

This scenario carries one area of high risk. There is a high lifestyle risk because to ensure you do not outlive your income you must greatly reduce your income.

Scenario 3: Immediate Group Funding for Life

This scenario carries two areas of high risk. There is a risk of experiencing a high loss. Though the average risk is nil, the perception is that it is high because the maximum is high. There is also a 100% bequest risk because, to ensure you do not outlive your income, you must forego the possibility of leaving a bequest.

Scenario 4: Deferred Group Funding for Life (DLA).

This scenario carries no areas of high risk.

Which scenario is the right approach for your retirement planning?

The best approach for you will depend on what is important to you, and your particular needs.

Australians who want to maximise their income while maximising their bequest with no potential loss and re willing to accept a 50% risk of outliving their income would invest individually with a higher level of income (Scenario 1).

Australians who want to eliminate the risk of outliving their income while maximising their bequest with no potential loss will need to sacrifice 50% of their income by investing individually with a lower level of income (Scenario 2).

Australians who want to eliminate the risk of outliving their income while maximising their income rather than leave a bequest and who do not worry about losses would invest as a group through an immediate lifetime annuity (Scenario 3).

Australians who want to eliminate the risk of outliving their income and are willing to sacrifice a little income to leave a bequest while significantly reducing their potential loss would invest as a group through a deferred lifetime annuity (Scenario 4).

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 Challenger, Colonial Life, Connelly Temple 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.