What is an investment-linked annuity?

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What is an investment-linked annuity?
Why have these been developed?
Decision factors

Note: Investment-linked annuities have recently become available in Australia, as part of a global push to protect retirees against the risk of outliving their savings.

In 2022, the OECD recommended all countries build retirement products that provide some level of longevity protection as a default for the pay-out phase.

“Lifetime income can be provided by annuities with guaranteed payments or by non-guaranteed arrangements where longevity risk is pooled among participants. The choice of the type of arrangement will depend on the desired balance between the cost of guarantees and the stability of retirement income. Flexibility could be provided by allowing for partial, deferred or delayed lifetime income combined with programmed withdrawals. Full lump sums should be discouraged in general, except for low account balances or extreme circumstances.”

One such product is an investment-linked annuity.

What is an investment-linked annuity?

An investment-linked annuity is a lifetime income stream where your income payments are guaranteed to continue for life but the level of those payments varies over time to reflect the performance of the chosen investment option(s).

This represents a new breed of retirement income product in Australia. Investment-lined annuities 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.

Need to know: Account-based pensions are the most common type of superannuation pension product in Australia. As the name suggests, payments are made from a super pension account in your name.

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.

These conclusions were endorsed by the Retirement Income Review and Treasury proposals for the Retirement Income Covenant. They are also consistent with OECD recommendations for designing retirement systems.

The main problem with allocating 100% of your superannuation to an account-based investment 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 withdraw each year. A growing body of research indicates that Australian retirees have a “fear to consume”, as the majority of superannuation funds only offer account-based pensions (ABPs) in retirement. Many retirees respond by only withdrawing the compulsory 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 2021. 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 2021 aged 65 or more

Other 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 and new medical treatments continue to extend life expectancy.

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 running out of money and mean you can confidently 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. These 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 the 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), that is, 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.

Note: The following examples are highly simplified to demonstrate some basic concepts. They should not be relied on when making decisions about a specific financial product.

Example 1

In this example, the initial level of payment specified by the investment-linked annuity gets set based on the retiree’s life expectancy at the time the annuity was purchased.

Consider a 66-year-old male, George, who has a $500,000 super account balance. The expected number of years of annuity payments payable to him over his lifetime, allowing for longevity improvements using the Australian life tables 2015–17 (using the 25-year improvement rate set), is 21.3 years. Therefore, his initial annuity income might be set to be $500,000 / 21.3 = $23,474 per year.

The investment-linked annuity provider guarantees the longevity risk (to ensure his payments continue for life — even if he lives to the end of the life tables) but not the investment risk (the price of income units will vary in line with underlying investment performance).

George chooses to use the same balanced option that his super was previously invested in. His annuity income will move up and down over time based on the unit price of this fund at the time of each payment. If over year 1 the unit price increased by 6% net of fees, then George’s retirement income will then be 6% higher, being $24,883 at the start of year 2.

Note that at inception, George’s income of $23,474 was slightly less than the regulatory minimum from an ABP (which is 5% x $500,000 = $25,000). However, the expected increase in his investment-linked annuity income over time is equal to the expected return of his investment fund (net of fees). For a balanced fund, George assumes 6% per year. If his unit price goes up 6% per year for 10 years, then his income would rise to $42,039 per year.

Example 2

George has an expectation that his investments will earn 6% per year, but he anticipates his actual living standard will keep pace with inflation.

He wonders if it’s possible to modify the annuity so that his income increases more in line with CPI than with full market returns.

George asks the provider: “Would you be willing to increase my starting income if I agree to forgo 3% per annum of all future returns?”

The investment-linked annuity can be modified to even out the expected income payments over the course of retirement in this way. This is done by bringing forward some of the expected future income and using this to allow a higher initial income when the annuity first commences.

A higher initial income can be paid to George. But instead of increasing in line with investment fund returns, his income will increase by the investment returns less 3%.

The annuity provider now converts his $500,000 into an income per year, but instead of using his straightforward life expectancy for this calculation, it adjusts the factor to 15.97 (which is actuarially equivalent to Example 1 but incorporating the 3% per year adjustment).

This gives a year 1 income of $500,000 / 15.97 = $31,309 per year.

By agreeing to his retirement income increasing by net returns less 3% per year, George’s starting income is $7,835 higher than in Example 1.

If George’s investment fund earns 6% per year net of fees, then his retirement income will increase by 3% per year (= 6% – the 3%), which is more in line with potential inflation so he can maintain his target lifestyle.

Chart 3: Projected income from each example (in today’s dollars) compared with an ABP

Decision factors

An investment-linked annuity can provide George with confidence to spend in retirement as he cannot outlive his income.
However, the income level changes over time based on the returns of the investment fund – like mainstream super products.
Most annuities offer a death benefit period — where a lump sum is payable to help protect the customers capital in the event of early death.
Many also offer a spouse’s option – so if one spouse passes away the income continues for the remaining lifetime of the survivor.
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 deliver an efficient lifetime income and offset the effects of future inflation.
It’s possible for an investment-linked annuity to offer investment choice including a switching process.

This article is an introduction only. Investment-linked annuities, and equivalent lifetime pensions from superannuation funds, are likely to be an increasing part of the superannuation landscape as the Retirement Income Covenant moves forward.

Check out which super funds offer income for life.

These products provide an alternative to traditional annuities, which many investors view as having poor value. They add confidence when used in conjunction with account-based pensions, which pass all risk to the retiree.

Centrelink means-test incentives were put in place for these and other lifetime income streams from 1 July 2019. This can provide an instant uplift in age pension income for retirees subject to means testing.

Age Pension incentive – worked example

A 70-year-old homeowner has $400,000 in superannuation. At present, his assets above the relevant Age Pension threshold of $280,000 get multiplied by the 7.8% taper rate and result in a deduction from his pension of $9,360 per year. In effect, his super balance reduces his Age Pension from $26,689 to $17,329 per year.

Fortunately, his superannuation fund is launching a lifetime income option. Moving his balance into this option could confidently pay him, say, 6.2%* of his investment, or $24,800 per year.

Only 60% of this $24,800 income gets assessed under the income test — which results in an instant age pension increase of $4,390 per year to $21,719 per year. The taper rate rules no longer apply to him, as it’s now the income test that applies to his age pension calculation.

The gain in his age pension is in addition to the higher and more secure income he’ll get from super for life – even if he lives to age 100 or more.

* Even higher starting incomes are possible at the expense of future increases to that income after it starts.

Investment-linked annuities could be very attractive to older or bereaved members of a self-managed super fund (SMSF) who no longer want to manage their own super assets and are happy for professional investment managers to do that on their behalf. This gives them less responsibility regarding investment and longevity risk, and more time to enjoy their retirement, with much less stress about running out of money — which is what retirement should be all about.

Note: The annuity rates in this article are simplified illustrations (to introduce basic concepts) using population mortality. The actual rate of income gets set by the provider and will be based on the anticipated mortality of the retirees who purchase that product and fees. In Europe, many annuities offer ‘individual underwriting’ which means that each applicant completes a short questionnaire to establish their health status. Those in poorer health may receive an increased pension per annum. This feature ensures that every pensioner gets a fair deal.

Jim Hennington, Peter Rowe and David Orford are from Optimum Pensions.