Retirement income: When is the optimal time to purchase a deferred annuity?

3 reasons to buy a DLA sooner rather than later

Once you retire, it’s worth considering the purchase of a DLA as soon as possible for three main reasons.

First, the earlier people invest before payments begin means the period until income payments start (called the deferral period) is longer. A longer deferral period means 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 begin. More money means that the payments can be higher.

Secondly, a longer deferral period means the bigger the decrease in the number of people who will receive an income (that is, the proportion of survivors). Less people to pay means that the payments can be higher.

Thirdly, a longer deferral period means the assumed earning rate built into the pricing of the deferred annuity should be higher, in theory at least.

This is because the provider should be able to invest in higher risk assets, which tend to provide higher returns over the long run, and avoid the short-term losses occasionally experienced by riskier assets. Also, they would be able to maintain their investment in riskier assets for longer before switching to safer, lower-return assets as the start date of income payments approaches.

The longer the deferral, the lower the chance of losses

If you look at the case of the All Ordinaries Accumulation Index (which tracks the Australian share market returns assuming reinvestment of dividends) you will find that it has experienced losses in real terms (after allowing for inflation) at the following rates over various rolling periods since the start of 1980 until March 2019.

The chance of losses 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, which 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?

Deferred annuities do not have to start paying an income at your life expectancy. Payments can start before or after you reach that date.

Let’s look at the results for various deferral periods based on the assumptions used in the linked article on longevity risk and how deferred annuities can help your savings last). For the sake of simplicity, we assumed no earnings are made for someone with retirement savings of $100,000.

Note that the figures in the table below have been rounded.

Note that the amount required for the deferred annuity investment and the income per year are related. The amount required for the deferred annuity investment is equal to the proportion of people who have to be paid (that is, the proportion of survivors at the end of the deferral period) times the average period for which they will need to be paid the income per year.

The calculation goes like this:

• Income per year x the percentage of survivors at the end of the deferral period (that is, 100% less the number of people who die each year, which is 2.5% per year given the assumption that all people die over a 40-year-period, times the number of deferral period years) 
• Multiply that result by the average remaining period over which the deferred amount needs to pay the survivors the income per year, which is half of the remaining period until the end of 40 years when everyone is presumed to have died.
• Take the example of a deferral period of five years: Income per year of $4,900 x 87.5% (that is, 100% of survivors less the number who die during the deferral period of five years, which is five times the 2.5% who die each year during the deferral period or 12.5%) is $4,287.50.
• Multiply $4,287.50 by 17.5 years (half of the 35 years remaining until 40 years).
• That gives a result which rounds to $75,000.

As you can see, as the deferral period gets shorter (see five-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 and maximum bequest reduce, while the maximum gain and 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 and maximum bequest increase, while the maximum gain and loss both decrease.

As with the conclusion in the linked article on  longevity risk and how deferred annuities can help your savings last), 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 on an early death.

In effect, the more the deferral period is shorter than life expectancy, the less you will benefit from the compounding of returns and the less benefit you will get from a higher income while still in retirement. On the other hand, the longer the deferral period extends past life expectancy, the less you will benefit from a higher income while still in retirement. Therefore, matching your deferral period to your life expectancy maximises the benefits and minimises the downsides of the deferred income you will receive from your investment in a deferred annuity.

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.