The Interim Report of the Financial System Inquiry observed that the retirement phase of superannuation is underdeveloped and does not meet the risk management needs of many retirees.
Indeed the financial risks faced by retirees are more complex than individuals in the accumulation phase, and include:
investment risk – the possibility of lower than expected returns affecting future income
sequencing risk – the possibility of negative returns at or near retirement affecting the market value of the investments which cannot be fully recovered in the future as pension payments are made reducing the level of investment
inflation risk – the possibility of high inflation which causes retirees to spend a greater proportion of their capital than expected
expenditure risk – the possibility of unexpected one-off payments in retirement which have longer term implications for future income levels
longevity risk – the possibility of running out of money as the retiree lives longer than expected
Whilst some of these risks can be mitigated through certain investment strategies or lifestyle decisions, longevity risk remains, as the time of one’s death is unknown. It is one risk where it is definitely better to pool the risk with others. As the Interim Report noted, “Managing longevity risk on an individual basis can lead to a dynamically inefficient allocation of resources.” The Report concludes the total cost of this inefficiency is likely to be substantial.
Before considering the longevity products available in the market, it is worth considering different groups of retirees who may benefit from longevity protection.
Segmenting the retiree market
We think it’s useful to divide the market into three broad categories:
Retirees with relatively small retirement benefits, say below $150,000. Most of these retirees will rely heavily on the age pension for much of their income in retirement. As such, longevity protection is already available for these individuals as the age pension is available for life, means testing permitting.
Retirees with significant retirement benefits, say above $1 million, who can live largely off their investment earnings. Although some of these retirees may wish to have some longevity protection, many will have sufficient assets so that they may not need to purchase any protection.
Retirees with retirement benefits between say $150,000 and $1 million. This group represents most retirees. They are likely to want a retirement income above the age pension, noting that the ASFA Comfortable Standard is about twice the age pension. Currently many in this group are ‘self-insuring’ their longevity by drawing down the minimum pension from their account-based pension and thereby not enjoying the actual retirement lifestyle that could be afforded. As the Interim Report noted, this is not an ideal outcome.
Potential post-retirement solutions
Three potential solutions were discussed in the Interim Report:
A lifetime annuity
A deferred lifetime annuity
Group self-annuitisation
Lifetime annuities are an insurance product that provides a guaranteed level of income for life (guaranteed by the issuing entity, not the government). However, as with all guarantees, there is a cost to the investor as capital is needed to back these long term promises. Nevertheless, lifetime annuities have become more popular recently.
Deferred lifetime annuities (DLAs) are a form of lifetime annuity where income payments are delayed for an agreed period. For example, a 65-year-old retiree may purchase a DLA that will provide a steady income stream after the retiree turns 85 and thereby guarantee an income above the age pension for the remainder of the retiree’s life. The advantage for the retiree is that they can run down the balance of their retirement benefit to age 85, knowing that the annuity payments will commence from that age.
The current tax rules relating to pensions provide a disincentive for the introduction of DLAs and therefore this product does not currently exist in the market. However their introduction would represent an important broadening of product availability.
Nevertheless, DLAs would still require significant capital as there remains considerable uncertainty about future liabilities for the insurer. The relative attractiveness of DLAs to retirees is also untested as the cheaper (and more efficient) DLAs would offer limited or no death benefit during the deferral period which may be unacceptable to some investors.
Group self-annuitisation (GSA) products are where participants invest funds into a pool of financial assets with regular payments made to surviving members. As the Interim Report noted, “Pooling mortality risk delivers higher income in retirement than an account-based pension that is drawn down at the minimum rate, while also providing significantly more protection against longevity risk.” This pooling enables members to share, but not completely eliminate, longevity risk without the need for any capital to back guarantees. Another way of expressing the outcome is that GSAs protect investors from idiosyncratic (or individual) longevity risk but not totally from significant systemic longevity risk.
GSAs will be offered by superannuation funds for account-based pensioners from the first quarter of 2015. The option pools an investment from each retiree’s account-based pension, which represents part (say 20-30%) of their total retirement benefit. The option pays investment earnings each quarter to support the pension payments whilst retaining the capital in the investment trust. Up to 95% of each investor’s capital would be returned on their death or exit from this investment option with the balance retained by the trust to be distributed to survivors on a six-monthly basis.
As the Interim Report noted, “GSA income is not guaranteed like annuity income, but it is expected to be higher due to the absence of capital requirements to back guarantees.” As a GSA represents a mutual pool of retirees supporting each other, this approach to longevity protection is also consistent with the ethos of many Australian superannuation funds.
No single solution for everyone
There is no single longevity product that is right for all retirees. For those with minimal assets, the age pension provides the only realistic protection. However, as superannuation benefits increase, a broader range of products need to be developed to provide longevity protection for retirees into their late 80s and 90s. After all, about half of all retirees will live beyond their life expectancy.
David Knox is a Senior Partner and National Leader for the Research Practice in Australia at Mercer.