The ongoing angst for most retirees is whether they will have enough money to last their retirement, including the mental discomfort of not knowing whether they will have the capacity to live a standard of living that is not on or below the poverty line.
Part of that angst when planning for retirement will of course be to ensure a person has enough savings (and to leave enough) to support the lives of two people (if a partner is involved). Many Australians also want to leave some inheritance for the kids and grandkids.
The problem of longevity risk, that is, outliving your retirement savings, which also can be expressed as running out of money before you die, has become a hot topic, especially as many Australians live into their late-eighties and early-nineties.
The government has relaxed the rules relating to the tax exemption on earnings from retirement savings, by now permitting potentially more flexible retirement products, that cater for longevity risk. One type of new product expected to hit the market (and one organisation has already released such a product) is deferred lifetime annuities.
Deferred lifetime annuities, the potential ‘new kids on the block’, are retirement products where the payment of the annuity is deferred to a later date. For example, an individual may purchase an annuity to start from the age of 80, in anticipation that their superannuation savings will run out by that age.
Why is the government worried about longevity risk?
The government and industry have grappled with this problem for decades and have not yet found a popular and affordable solution to tackling longevity risk. The lack of success by policy and product experts is partly political (not willing to tell Australians how they should invest their retirement savings), partly due to lack of innovation, and in my view, primarily due to a lack of focus on the retirement phase by superannuation funds (until very recently).
More recently, the federal government has introduced laws to encourage innovative retirement products designed to minimise market risk (such as another Global Financial Crisis), inflation risk (maintain purchasing power) and longevity risk.
Since 1 July 2017, the government has extended the tax exemption on earnings in 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.
In plain English, the difference between a pension and an annuity, is that a pension is an income stream offered by a super fund, while an annuity is an income stream offered by a life insurance company. In reality, annuities (more accurately known as immediate annuities) are more commonly known as guaranteed income streams, for a fixed period, or for a person’s lifetime, or a variation of those two options. For a backgrounder on annuities generally, see SuperGuide article Peace of mind, at a cost: 10 things to know about annuities.
How feasible are guaranteed pensions for everyday Australians?
The dream retirement product perhaps is a lifetime pension or annuity that keeps pace with the cost of living and that provides this income until the day you expire; so you don’t outlive your retirement savings. An example of such a retirement product is the lifetime pension that many of our members of parliament receive, courtesy of the Australian taxpayer.
Obviously, to create such an income stream for regular Australians, we need to ensure it is affordable. The Age Pension could be described as a government-funded (taxpayer funded) lifetime annuity.
Note: Australian retirees and future retirees are dealing with competing objectives of maximising income but ensuring their savings last for a lifetime. Federal government retirement policy, especially Age Pension policy, is not designed to encourage plans for bequeathing assets after you die, but estate planning remains an important consideration for a large number of retiring Australians. If you purchase an annuity to protect your retirement income, what happens to your savings if you die well before your time?
Any guarantee in the investment space costs money because the provider of the guarantee must not only meet that commitment, but also must make a profit for the business offering such a guarantee. In the recent past, the price of such guaranteed retirement products (due mainly to historically low interest rates, notwithstanding recent strong investment markets) has meant most retirees would rather take their chances by carrying their own longevity risk.
Annuities lost favour for awhile, but with the Global Financial Crisis devastating the retirement plans of many Australians, the enticing prospect of someone else worrying about investment risk and longevity risk became more attractive for those still reeling from losing retirement capital. Even so, many Australians don’t seem to like the idea of losing 100% of the capital used to purchase the annuity if they die young (although many annuity products do offer minimum payment periods, which mean surviving family can still receive some payments, or guarantee periods during which capital can be returned on death).
If you have good genes and good luck in the ‘long life’ department, then an annuity can be a financially sound idea. If you die early, then an annuity may seem like a waste of money.
Note: According to annuities expert, Sean Corbett, the legislation for DLAs permits products to be offered which allow capital to be returned for a period of up to life expectancy. The amount allowed to be returned is up to 100% for a period of up to half of your life expectancy in the case of death, and an amount that declines in a straight line over your life expectancy in the case of voluntary withdrawals.
Sean Corbett, now a SuperGuide guest contributor, has written an excellent article explaining 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. Sean also provides a comparison of different retirement options, and under what circumstances such products would be most beneficial for retirees. The link to Sean’s article appears at the end of the article you are now reading, and I highly recommend reading it, but briefly his conclusions are set out below.
Is a deferred lifetime annuity suitable for your circumstances?
Sean describes lifetime annuities as “insurance products that address the risk of running out of money in retirement by living longer than the money lasts.” The product provider achieves this by pooling the money of investors (purchasers) and using the money from those who live shorter lives, to fund the income of those who live longer lives.
The flaw of such a product is that those who live shorter lives don’t really benefit from the product, and so there are individual losers and winners, and this prospect means many Australians view annuities as penalising those who die before their time.
Sean believes deferred lifetime annuities (DLAs) can help resolve this negative aspect associated with immediate annuities. He suggests DLAs will enable Australians to insure against the period where the individual believes the risk (of running out of money) exists, for example, after they reach the age of 80, or 75, or 85, or whatever age is decided upon by the individual and product provider.
According to Sean, by lowering the amount that needs to be invested in the annuity, by deferring the start date to some time in the future, means the maximum loss is a lot lower, if you happen to die young. Sean explains how this works in his article (see link later).
I colloquially call the DLA approach as ‘hedging your bets’ which is essentially what risk management is all about. If you die before the age at which the DLA commences (you die before the age of 80, or 75, or 85, or whatever age is decided upon) then generally you receive no payments, although the legislation allows for versions of DLAs to be developed where your estate receives some type of capital repayment.
Considering 4 retirement options (including a DLA)
In Sean’s article he considers an individual funding a retirement with a given amount of savings in all scenarios (for simplicity, Sean uses $100,000 to illustrate the scenarios):
- Funding a retirement for life expectancy (20 years)
- Funding a retirement for life (up to 40 years)
- Group funding for life (purchasing an immediate annuity)
- Combination of individual funding and deferred group funding for life (purchasing a deferred lifetime annuity).
Individual funding for life expectancy: High risk of outliving your income, and high risk of suffering a drop in income: because if you live longer than 20 years in retirement (beyond age 87), then you will have no income and no assets to leave family. This option may be feasible for those Australians who want to maximise income, and want to maximise chances of a bequest (leaving assets to family), but accept higher chance of outliving their income.
Individual funding for life (up to 40 years): Choosing this scenario with the given amount of savings, means accepting half the annual income available under the 20-year scenario, but it does eliminate the risk of outliving income while maximising any bequest (if the individual dies early).
Group funding for life through an immediate life annuity: Opting to purchase an immediate lifetime annuity eliminates the risk of outliving your income, but generally means a bequest is not an option. Sean says such a scenario does present two risks: a risk of experiencing a high loss if you die young, and also a bequest risk.
Combination of individual funding for life expectancy, and deferred group funding for life: Sean says opting to purchase a deferred lifetime annuity in the scenario outlined in his article may suit individuals who want to eliminate the risk of outliving their income and who are willing to sacrifice some income to leave a bequest, while also reducing the potential loss of investing via an annuity group (if they happen to die early).
For more information on these scenarios, and further explanation of deferred lifetime annuities, and comparisons with regular annuities and regular superannuation pensions, see Sean Corbett’s SuperGuide article Guest contributor: Reducing the risk of outliving your retirement savings.
For more information about annuities generally, see SuperGuide article Peace of mind, at a cost: 10 things to know about annuities