By Daniel Archibald | CFA
Developing financial strategies that look to optimise outcomes of financial security and independence can be difficult. This is primarily due to the vast array of variables that need to be considered: age, family situation, income, job security, health, savings goals, economic conditions, etc. Furthermore, as with all variables, these factors will change over time, and sometimes in unexpected ways. Thus, being able to project an individual's wealth over an extended period, and implement strategies to maximise this projection, can (more often than not) be a well-educated guess.
Retirement planning can be a little simpler. Lifestyles are mainly set and planning timeframes are reduced. Unexpected events will still occur, but even then, many of the financial risks of these can be mitigated through savings buffers and social security support. Good planning can see a retiree's wealth last throughout their retirement years, supporting their living expenses and providing for the best possible level of lifestyle.
One of the biggest risks that a retiree faces in retirement is that of spending their way through their savings and a key factor for this is their life expectancy. Longevity risk, the risk of outliving one's retirement nest egg, is of growing concern, particular as life expectancies continue to steadily grow with medical advances. In the past, retirement savings were meant to cover 20 maybe 30 years of post-work life, but now, retirement savings need to last 30-40 years. The age pension, which offers a safety net for all Australian retirees, can support individuals should their retirement savings become depleted, but it is likely to require a reduction in living standards. And demographic trends towards an older population adds the risk of future generations being unable to fund such social security programs.
The advent of superannuation in Australia was designed for this particular need. And at its outset, many superannuation or pension programs were set up to provide a retirement income for life. This was based on the individual's working life and salary levels and is commonly known as a defined benefit fund. However, over time, most superannuation plans have converted into defined contribution funds, where retirement income is not set and individuals have more control over how they want their retirement savings to be invested and withdrawn.
This brings us to the 'annuity puzzle' or gap. Annuities have a similar structure to that of a defined benefit fund, in that they can offer a set income for life. However, instead of being negotiated by employers based on an individual's working life, they are private financial products that can be purchased using other savings. They are essentially the a reverse life insurance policy; providing more value the longer you live (whereas life insurance provides more value the shorter you live) and covers opposite risks (living too long vs premature death).
Annuities are usually purchased with a lump sum (but can also be purchased overtime while working through regular contributions) and they can be set to start immediately (usually at retirement) or can be delayed to start at the far future date (date that other retirement savings are expected to be depleted). The lump sum can usually be repaid if the individual passes away within a short period from commencement and many annuities can be set-up to cover a couple (joint annuity).
A key feature of financial planning is risk mitigation, and annuities directly address longevity risk. But this is where the 'annuity puzzle' seems to arise, with a relative lack of interest in annuities from the vast majority of retirees. Life insurance advocates commonly complain that Australians 'think they are invincible' and thus don't see a crying need for death cover; but if that is the case, wouldn't the opposite of life insurance, an annuity, seem like a rational choice (i.e. "I am going to live forever therefore I should buy an annuity"). A key factor in purchasing an annuity can be the opposing concern of dying too early to reap its full benefits. Even with some level of refund in the event of early death, annuities are still likely to pay less benefit than they effectively cost: The annuity provider needs to make profit in accepting a retiree's longevity (and investment) risk. It should be worth noting that lack of annuity utilisation is seen throughout the globe (i.e. it is not just an Australian phenomenon).
Of course, annuities are not the only way in which to mitigate against extended life spans and a well structured investment strategy can provide the best of both worlds. Such a strategy can provide enough income to meet an acceptable level of living expenses, while at the same time protecting the real value of a retiree's wealth. Diversification, exposure to growth assets and regular reviews of the investment strategy are the foundation of a sound plan to self-insure against longevity risk.
The take-up of annuities may well come down to one's belief on their own mortality probabilities (i.e. Someone with parents who both lived to 100 might get good value out of an annuity) as well as their confidence in developing an alternative, self-insurance plan. Annuity providers will also need be trusted to be around for a long period of time (i.e. not take on excessive investment risk) and to price annuities at reasonable rates. But overall, the underinsurance problem in Australia could well extend to the other side of the spectrum and explain why we might also have an underappreciation of annuities.