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One of the major challenges when planning your retirement income is to try and ensure you maximise the income you receive from savings while at the same time ensuring your savings last for as long as you do.
There is no simple solution or a one-size-fits-all approach. That said, deferred lifetime annuities could provide part of the retirement income puzzle for many retirees.
What is a deferred lifetime annuity (DLA)?
A DLA is a form of lifetime annuity that will pay the owner a guaranteed income stream, starting at a future date, for as long as they live after that date. This can give people confidence to spend more of their savings in the early, active years of retirement with the security of knowing their money won’t run out.
There are of course costs and benefits to weigh up when considering a DLA.
In this article we will look at four retirement funding scenarios, to see how they compare and who they may suit.
- Individual funding for life expectancy (enjoying higher income but high risk of running out of income)
- Individual funding for life (sacrificing income to counter the risk of running out of income)
- Group funding for life through an immediate lifetime annuity (guaranteeing income at the risk of losing your capital if you die early)
- 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).
Assumptions
For simplicity, we will consider an example of someone retiring at age 65 with $100,000 in savings who is expected to live on average for 20 years (currently true for an Australian male aged 65, while women can expect to live an extra three years on average).
We will assume people live for between 0 and 40 years and that they pass away each year at the same rate (in the real world they tend to pass away closer to the average but for the purposes of this article this is a reasonable assumption which doesn’t change the underlying outcome).
So, at the start 100% of people will be alive and at the end of 20 years 50% of people will still be alive while at the end of 40 years no people will be alive and people live on average for 20 years.
Again for simplicity, we will ignore future earnings on your savings to make the fundamental lessons clearer.
Scenarios
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?
This is difficult 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 your average 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, ignoring investment earnings.
The average total income for people who take this approach will be $75,000. This is 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. 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.
Consequence: Obviously there is a problem for the 50% of people who live longer than 20 years. They 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 investing as an individual is to lower the income you receive to make your money last for the entire period you might live, 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 (40 years).
The average total income for people who take this approach will be $50,000. 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.
This means the average bequest for people who take this approach will also be $50,000.
Consequence: Halving income but receiving it over a 40-year period has solved the problem of people living for longer than their income. But it has come at the cost of having their income halved.
Another problem with this approach is that, if you are providing your retirement income from your super savings through an account-based pension, the minimum withdrawal requirements mean your income cannot be set sufficiently low to make it last for life. Instead, the minimum drawdown rates are designed so your super will run out at life expectancy.
The minimum withdrawal is normally set at 5% of savings for a 65 year old, gradually increasing to 14% for those aged over 95. These rates have been temporarily reduced by 50%.
Is there another way to deal with the problem of having to drastically reduce our income to make sure it lasts for life? There is, but it means not investing as individuals.
3. Group funding for life through an immediate lifetime annuity
As with many other types of risk, insurance products have been developed to allow people to offset the risk of outliving their savings.
Lifetime annuities are insurance products that address longevity risk; that is, the risk of outliving your retirement savings. They do this by pooling the money of people who invest in them and using the remaining money from those who live for less than the average life expectancy to pay an income to those who live for longer than the average.
Let’s return to our example of someone retiring at 65 with $100,000 in savings to produce retirement income.
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. 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. 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. Hence, the average across the whole group will be $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 other gains or losses on death to weigh up.
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 a loss (because they don’t know how long they will live and because deaths are spread over the period), and on average there is no gain or loss, individuals will experience losses and gains and the maximum loss is high. There is also no scope to leave bequests.
So, how can we manage 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
Deferred lifetime annuities were developed to help address the potential loss of capital from traditional lifetime annuities outlined above, following a change in the rules from 1 July 2017.
DLAs lower the amount that needs to be invested in the annuity, thereby lowering the maximum loss. They do this by deferring the start of the lifetime annuity into the future, leaving the remainder of the person’s funds to cover the period until the lifetime annuity kicks in 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 the period when the risk exists? This is what deferred lifetime annuities do.
Let’s 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, they can receive $4,000 a year for life and reduce their potential maximum loss.
They will reduce their annual income slightly 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 DLA that will provide them with $4,000 a year from 20 years until they die.
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 for half the amount of time (20 years rather than 40 years).
Let’s compare the pair. If $100,000 is invested in:
- An immediate lifetime annuity it can provide $5,000 a year for up to 40 years
- A deferred lifetime annuity it could provide $20,000 a year (as it only needs to provide an income for half the people (doubling the income it can provide from $5,000 to $10,000) for half the time (doubling the income it can provide again from $10,000 to $20,000)
Hence, $20,000 invested in a DLA 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. 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. 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.
The average bequest for people who take this approach will be $20,000. 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.
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, with losses 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 savings without having to drastically reduce their level of income, while also allowing 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 four scenarios
The table below summarises the key figures under the four 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.
Individual funding for life expectancy | Individual funding for life | Immediate group funding for life | Deferred group funding for life | |
---|---|---|---|---|
Income per year | $5,000 | $2,500 | $5,000 | $4,000 |
Income lasts for | Life Expectancy | Life | Life | Life |
% who outlive income | 50% | 0% | 0% | 0% |
% who leave bequest | 50% | 100% | 0% | 50% |
Average total income | $75,000 | $50,000 | $100,000 | $80,000 |
Average bequest | $25,000 | $50,000 | $0 | $20,000 |
Maximum bequest | $100,000 | $100,000 | $0 | $80,000 |
Average gain | $0 | $0 | $0 | $0 |
Maximum gain | $0 | $0 | $100,000 | $60,000 |
Maximum loss | $0 | $0 | $100,000 | $20,000 |
Risk summary of the four scenarios
Lifetime annuities not only remove the risk of outliving your income, but they can also reduce or remove other risks. Two of these risks are:
Investment risk: Investment returns tend to be positive and relatively stable over the long term, especially real returns after allowing for inflation. But in the short term markets can be volatile and lead to losses. People who invest individually and who are not investment professionals are particularly vulnerable to investment risk.
Inflation risk: While this risk may be low, particularly over the longer term, it is never nil for individual investors.
As the income from lifetime annuities in Australia is required to be guaranteed, the returns of the investments backing them are guaranteed. This means 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 provided under each scenario. A low income or no income places your lifestyle at risk.
- Bequest risk: The risk to your ability to leave an inheritance on death.
- Loss risk: The risk of a loss of capital that is not returned as income.
The table below summarises the risks in each of the scenarios (assuming any lifetime annuities are indexed to provide inflation protection).
Individual funding for life expectancy | Individual funding for life | Immediate group funding for life | Deferred group funding for life | |
---|---|---|---|---|
Investment risk | Low risk | Low risk | No risk | Low risk |
Inflation risk | Low risk | Low risk | No risk | Low risk |
Longevity risk | High risk | No risk | No risk | No risk |
Lifestyle risk | High risk | High risk | No risk | Low risk |
Bequest risk | High risk | No risk | High risk | Low risk |
Loss risk | No risk | No risk | High risk | Low risk |
Scenario 1: Individual funding for life expectancy
This scenario carries three areas of high risk. There is a high risk of outliving your income, 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 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 your needs and what is important to you.
Australians who want to:
- Maximise their income while maximising their bequest with no potential loss and are willing to accept a 50% risk of outliving their income would invest individually with a higher level of income (scenario 1)
- 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)
- 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)
- 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.
Bob Coleman says
Excellent article, thank you.