Untangling the mandatory annuitisation ball of string

Rice Warner’s public voice on the merit of lifetime annuities, and our subsequent Financial System Inquiry submission on the matter were each aimed at highlighting a number of anomalies in accepted wisdom concerning mandatory annuitisation of superannuation lump sums.

We sought to highlight not only the flaws, but offered up a generic solution, the Rice Warner Retirement Incomes Solution, the details for which you can find here.

Our position is clear and consistent: lifetime annuities have a place as a choice option for risk averse members.

We also believe they could be appropriate as part of a default strategy were they to be purchased at advanced ages. We consider buying them gradually over five years from age 85 is a valid option for trustees to consider. The rationale is:

• At age 85, one third of people are demented and they should not be making financial decisions.
• Many elderly people are subject to fraud, often from family members, so an annuity protects against others taking their benefit away.
• Lifetime annuities have social security advantages which will then be helpful for the majority of retirees of this age.
• Lifetime annuities offer relatively good value at advanced ages as the cost of the guarantee is far more modest than the cost at retirement.
• Buying over a five year period reduces the risk of low interest rates or annuity prices at the time of purchase.

However, using a lifetime annuity as part of a default strategy at retirement has too many risks. As well as being inflexible and non-commutable, our research shows the retirement outcome to be sub-optimal for members. In our submission to the FSI, we have shown how the cost of guarantees could be reduced by changing the statutory reserving basis. We would welcome this change as it is necessary to offer retirees a reasonable choice – we also believe other life companies would enter the annuity market and make it more competitive.

Lifetime annuities have been promoted by a number of influential people as being the solution to developing a retirement incomes market in Australia. This was a recommendation of Ken Henry (Australia’s Future Tax System Review) and others who argue (incorrectly) that a shift to lifetime annuities would reduce the assets required in retirement by about 15 per cent.

The usual additional arguments given to support annuitisation of retirement benefits are:

• There is system leakage when people take lump sum benefits or die leaving their super as a bequest. These funds are not used to provide a retirement income.
• Australians would prefer certainty of income in retirement as they have no opportunity to recover any losses from future wages.
• Australians prefer a regular income from an annuity as it is similar to the regular wage they received when they were working.

Yet, as our aforementioned submission to the Financial System Inquiry shows, the fallacy of these arguments is that – far from being more efficient – mandatory annuitisation would actually lower retirement incomes and add to social security costs. Frankly, the cost of the guarantee is too high and the low number of sales in Australia indicates that most retirees and their advisers already understand this.

Obviously lifetime annuities do have a place in some retirement portfolios but not in a default fund as members should not be put into a product which cannot be changed if they subsequently review their own financial circumstances. This is a fairly simple premise from which to understand our core position.

Other facts: Why do annuities offer relatively poor value? There are two key reasons:

• Retirees have a long-term need for income which should be maintained in real terms. As the average term of retirement now exceeds 20 years (and the period is growing since future generations will be longer-lived), their time horizon is long-term. Consequently, the underlying assets backing their retirement income need to be heavily based around growth assets which will generate real rates of return. Conversely, lifetime annuities are backed by conservative investment portfolios (less than 30 per cent growth assets in the portfolios), so they under-perform other investment strategies.
• The products provide very strong guarantees and this requires the life company to be conservative in making pricing assumptions and to set up significant capital reserves. Most life companies are not prepared to invest the levels of capital required to back a portfolio with significant amounts of growth assets. This forces them to have an emphasis on defensive assets which over long periods are lower yielding than growth assets. Many life companies have withdrawn from the marketplace as they don’t believe they will get a fair return on the capital they need to deploy.

Rice Warner believes the products could be made more attractive by changing the reserving basis and allowing the life companies to invest in appropriate long-term assets to back these products. We consider the pool should be valued in a similar way to a defined benefit portfolio.

As an example, let us assume that APRA required the assets backing a life annuity pool to be 105 per cent of the liabilities. If the assets were invested heavily in long-term investments (say 75 per cent growth assets), this ratio could fall to (say) 80 per cent during a global economic crisis such as occurred in 2007/8.

We know that there will be a reversion to the mean in many investment markets and that the underlying investments will recover. Further, their income will not reduce by much (if anything) so it is reasonable to allow the life company to manage the recovery of the investment pool.
APRA would require a recovery plan which may include:

• A requirement that the assets recover to 105 per cent of liabilities within three years.
• A requirement for some additional shareholder capital to be provided should the ratio fall below (say) 85 per cent.
• Some limitation on issuing new policies until the financial position has recovered.
• Another measure (last resort) would be to have a temporary hold on indexation of policies (but the increase would be paid at a later date).

The Rice Warner proposal is that if some (pre-determined) level of variability is allowed and anticipated, the pricing margins and capital requirements can be less stringent and greater allocations to growth assets can be supported.
The underlying investment portfolios would intrinsically generate higher returns and there will be a smaller charge to pay the cost of the lower capital requirements. This approach would support higher returns from annuities and consumers would pay less for their guarantee.

– Michael Rice, CEO