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Note: Investment-linked annuities are not yet available in Australia, but some financial services companies are currently looking into developing them.
An investment-linked annuity is a lifetime income stream where the retiree’s income varies to reflect changes in the value of a selected investment option. A simple way to think about this is that it represents a new breed of retirement income product in Australia. They provide longevity protection to ensure the retiree never runs out of money but also offer a choice of investments used to support that income. This design provides an opportunity to benefit from market returns over time. The longevity protection is provided by way of insurance.
Why have these been developed?
In 2014, the Financial System Inquiry (FSI) concluded that account-based pensions (ABPs), used in isolation, cannot efficiently convert superannuation assets into retirement income. Modelling by the Australian Government Actuary (AGA) showed that retirement income can be 15-30% higher by combining retirement products, particularly by allocating some money to a lifetime income product.
The main problem with allocating 100% of your superannuation to an ABP in retirement is you don’t know how long you are going to live. This means you don’t know how much income you can safely draw from your ABP each year. A growing body of research indicates that Australian retirees have a “fear to consume”, as the majority of them only draw out the required minimums each year, which means a relatively large balance is left unused on death.
Retirees’ concerns over how long they could live are valid. Chart 1 shows the actual age at death for Australians aged 65 or more who died in 2016. It demonstrates how retirees simply can’t tell how long their retirement timeframe is.
Chart 1: Actual age of death for all Australians who died during 2016 aged 65 or moreOther research indicates that age of parents’ death may not be a good indicator of the age of the retiree’s death, as causes of death may differ.
Over 2,000 years ago, the Romans solved this problem by using the annuity — probably the oldest financial product in the world. Annuities remove the risk of “money running out” and mean you can be confident to spend your entire income. US studies show that retirees on lifetime incomes (e.g. annuities) exhibit higher levels of satisfaction in retirement, even taking the wealth effects into account.
Chart 2 is based on a University of Michigan study of over 20,000 retirees. It shows that those who annuitised part of their retirement savings have higher levels of retirement satisfaction than those who did not.
Chart 2: US retiree satisfaction rates by extent of annuitisation, full sample, 1998-2010
Many financial professionals, however, baulk at the current cost of traditional annuities. In today’s low-interest rate environment, annuities are often perceived as poor value for money. But part of the pricing of a traditional annuity is not just insuring longevity risk but also providing investment guarantees — often for 30 or more years into the future — and these are very expensive to provide.
But what if lifetime annuities didn’t need to include investment guarantees? What if retirees with a balanced attitude to risk could still benefit from longevity protection but maintain some exposure to growth assets — as they do with an account-based pension. For these retirees, the ideal retirement product could be an investment-linked annuity (or real lifetime pension), i.e. an ABP with longevity protection that doesn’t decline in real terms over time.
With an investment-linked annuity, each year’s income varies based on the performance of a selected investment option, rather than as a specific dollar amount of income.
Chart 3: Projected income from each example (in today’s dollars) compared with an ABP
- An investment-linked annuity can provide George with confidence to spend in retirement — he cannot outlive his income.
- However, the income level changes over time based on the returns of the investment fund.
- Most annuities offer a guarantee period — meaning a minimum of, say, 15 years of income is payable in the event of early death.
- By agreeing to modify the annuity, George can achieve a higher income at inception which then increases more in line with a CPI target (as opposed to a lower income that increases with full net returns).
- Choosing an investment-linked annuity with a suitable exposure to growth assets can help to deliver an efficient lifetime income and offset the effects of future inflation.
- It’s possible for an investment-linked annuity to offer investment choice through a switching process.
This article is an introduction only. Investment-linked annuities, and equivalent lifetime pensions, are likely to be part of the superannuation landscape as the government’s proposed Retirement Income Covenant moves forward. They provide an alternative to traditional annuities, which appear to many investors as having poor value, and account-based pensions, which carry longevity risk.
New Centrelink means-test incentives were put in place for lifetime income streams from 1 July 2019. This can provide an instant uplift in age pension income for retirees subject to means testing.
Investment-linked pensions or annuities could be attractive to older or bereaved members of an SMSF who no longer want to invest their own superannuation assets and are happy for professional investment managers to do that on their behalf — thus, giving them less responsibility regarding investment, more time to enjoy their retirement, with much less stress, e.g. about running out of money — which is what retirement could be all about.
Jim Hennington, Peter Rowe and David Orford are from Optimum Pensions.