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Retirees love a guaranteed income: So why do they shun annuities?
“Tis said that persons living on annuities
are longer lived than others – God knows why,
Unless to plague the grantors – yet so true it is
That some, I really think, do never die.”
Lord Byron may have over-estimated annuities’ effect on longevity, but as a notoriously profligate spender he would have appreciated their promise of regular income.
Annuities have largely struggled to build momentum in Australia, but with 2.5 million retiring over the next decade, and 72 per cent of retirees saying they would be happier with a guaranteed income for life in retirement, the time for annuities might have finally come.
One of the reasons why annuities have been scarcely used in Australia is “the annuity puzzle,” says associate professor Anthony Asher of the University of New South Wales.
“This is a well-known academic puzzle that applies pretty much in the whole English-speaking world,” he tells The Golden Times. “It’s fairly commonly accepted that lifetime annuities offer retirees a great way to protect against longevity risk and investment risk – you get a guaranteed income stream for life, effectively insuring against the risk of depleting one’s savings – but few people actually buy an annuity with their retirement savings.”
Part of the reason, says Asher, is that the Australian retirement market opted for lump sums for a long time, most likely because the means test excluded the family home. “That has always been a little bit tough on assets. So, it hasn’t been a great idea to have an annuity, so that’s part of it.”
Many people also have a strong desire to either leave a financial legacy to their heirs or charity. Annuities may have suffered from the belief that if a retiree passes away earlier than expected, the insurance company keeps the remaining funds, which could have been passed on to beneficiaries.
However, this is an outdated belief; annuities today provide a death benefit. People may also not know that when the annuity is part of the portfolio, the income from the annuity means that the drawdown from the other investments is lower, leaving a larger estate balance.
The Government requires that the access to capital is restricted as retirees age through the capital access schedule (CAS), which applies to lifetime income streams. Death benefits can cover the initial purchase price for an extended period but are also subject to the constraint and cannot be paid when someone outlives their life expectancy. There is a small window where not being subject to the CAS would provide a higher death benefit.
Also, for many people there is a higher age pension entitlement, further extending the balance of other assets. It is only for those limited years where the CAS is limited by the Government that the estate balance will be lower for some people holding an annuity.
Annuities have also suffered from comparisons of returns. Until recently, the only annuities that were permitted in Australia had to be invested effectively in CPI-linked government bonds, so the investment return was lower than alternative investments.
“The way Australia has structured things, with franking credits, means that fixed-interest investments have yielded poor returns relative to equities,” says Asher. “Thanks to franking credits, when you come to the pension phase in super, income from your assets is tax-free. Currently, for example, you can get 1.5 per cent on an inflation-linked government investment, and you can get five per cent as the average grossed-up return on share dividends. Three times as much; that’s difficult to argue with.”
Aaron Minney, head of retirement income research at Challenger, which dominates the annuity market with a 90 per cent share, says comparing annuities to equities is the wrong way to think about a retirement portfolio.
Instead, he says annuities should be compared with other defensive assets; and if so, the return comparison is not unfavourable to the annuity, being sometimes slightly higher, sometimes slightly lower. “We certainly don’t argue with equity investments. Retirees with the protection of a lifetime annuity can invest more into equities and other high-growth assets,” he says.
Another development favourable to annuities has been the oft-stated determination of the Government to get superannuation funds to consider products that meet their members’ needs in retirement.
Since July 2022, when the Retirement Income Covenant took effect, super fund trustees have been required to formulate, review regularly and give effect to a retirement income strategy for members either approaching or in retirement.
It represents a big opportunity for the $16 billion annuity market to grow, says Minney. “Certainly, we see super funds as an emerging sales channel for annuities, and other longevity product sales, because the funds are now compelled by law to help their members prepare for retirement.”
Another growth path in terms of providing what clients want is protection against inflation. When people buy an annuity, they’re protecting their income for life.
“For a long time, they didn’t really have to worry about inflation. But in 2022, when inflation took off, the investment-linked options did not protect against that cost-of-living increase. People suddenly realised that they needed their income protected against inflation.”
Challenger prefers the term market-linked to investment-linked, as its annuities are not linked to a specific investment, but to a combination of markets. “It’s trying to find an option for people to invest in a balanced fund or a growth fund while having income that’s still annuitised.”
Although the annuity is guaranteed income for life, Minney says the crucial point is that it should not be the entire retirement income solution, with retirees diversifying their retirement income because of the three phases of retirement – active, passive and frail.
