Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 89

Longevity risk solutions for retirees

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:

  1. 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.
  2. 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.
  3. 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:

  1. A lifetime annuity
  2. A deferred lifetime annuity
  3. 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.

3 Comments
Robert Amery
December 13, 2014

We desperately need more innovation in this area and its good to see that the industry hasn't been deterred by previous valiant attempts to import ideas into our market, like the flash in the pan account-based "money for life" structured products a few years ago.

That's not to say we should be reinventing the wheel here in Australia, though - retirement product markets are far more developed in Europe and South America. There must be a wide range of proven products that should be evaluating and adapting for our market.

For example, these tontine-like GSAs seem simpler but what are the expected returns? both now and if you're lucky to live longer? Obviously some members of the pool will be getting far greater returns than others. What's the distribution of expected return profiles?

GIven that the 'bonus' longevity payments are uncertain in terms of both time and timing, can comfort be drawn from the overseas experience? Given that 10-15 years must pass before the longevity protection kicks in, how are GSAs regulated offshore to hold the promoters accountable and mitigate against "promise ratchet'.

The absence of a costly capital buffer presumably means their longevity assumptions are deeply conservative, I'd imagine. Did offshore GSAs manage to dodge the
longevity underestimation disaster which hit the UK life insurance industry?

Apologies for all the questions but my desktop research has yielded little and i'm very keen to know more, as my wife is a member of one of the funds recently signed up to a GSA product. She needs more convincing then me though, as she's likely to be around longer!

Christine
November 21, 2014

As retirement funding discussions morph from considerations of superannuation and pension products to considerations of retirement outcomes, housing wealth has to become part of the discussion. This won’t be popular and the mechanisms to tap into housing wealth are not straight forward, but it is necessary and inevitable.

Perhaps Treasury’s next Intergenerational Report, due out early next year, will provide the impetus for public policy settings to move forward on this. We need to move forward both in the area of the full family home exemption of the assets test but also understanding how asset rich, cash poor retirees impacted by the removal or watering down of the exemption can go about tapping into housing wealth. Current private sector offerings of reverse mortgages and home reversion products are not universally available and it is unclear how much capacity there is.

One solution is a universally available, government run scheme whereby seniors with substantial housing wealth can continue to draw an age pension but accrue a debt against that wealth. Ramani suggested something along these lines in another comment recently, and the final paragraphs of Graham Hand’s article last week outlined Robert Merton’s views on the topic. Last year’s Grattan Institute report “Balancing budgets: tough choices we need” also made this suggestion.

Ramani
November 21, 2014

David's excellent gist needs to be assessed in the context of two behavioural imperatives and one all-too-common omission, exacerbated by the tyranny of hindsight perception.

Focusing on the middle group most in need of longevity protection, the behavioural irritants (against which allergy medicine has woefully failed) are the impulse to provide for inheritance and the inequity of taxation. While a sensible retirement policy may be able to provide, in its stable state, for the saver's twilight years (make it a saving couple, for partners), no system can sustainably fund the grandkids' future. Especially when underwritten by the taxpayer poorer than those protected, already enjoying post- retirement benefits tax-free.

This brings us to tax: the taxpayer funding the asset-rich and cash-poor elders by exempting the family home from assets test while the offspring can blithely access the estate is plainly inequitable and given unfunded age pensions, constitutes a mortgage on the yet-to-be born. Inconceivable!

The omission relates to the fact that super is only a part of the story. Non-super assets, financial or otherwise, matter too. While the financial assets are obvious, less so are the valuable family links, which our oxymoronic 'civilisation' treats them as one-way: parents must provide for kids while kids can outsource them to the taxpayer, only turning up to claim when the probate to the estate is granted. This asymmetry has a social cost and can only be remedied by infusing a dollop of Confucianism into our ethos.

None of this is easy, especially as hindsight, by definition, is antecedently unavailable (blame ophthalmology, if you will). That is not an excuse for inertia.


 

Leave a Comment:

     

RELATED ARTICLES

Retirement income products - what's ideal?

Beyond financial solutions for longevity

Overcoming loss aversion in retirement income

banner

Most viewed in recent weeks

Buffett's meeting takeaway: extreme caution

Warren Buffett's annual meeting of Berkshire Hathaway showed he has not been 'investing while others are fearful' during the crisis. lt's a reminder to take caution and preserve cash.

Welcome to Firstlinks Edition 356

Few investors are as influential as Warren Buffett, although for the moment, the market is ignoring his caution. The annual meeting of Berkshire Hathaway revealed Buffett did not use the heavy market falls in February to buy shares. Rather than 'buy when others are fearful', he was a net seller of US$6 billion for the quarter, disposing of all airline shares. Berkshire is sitting on US$137 billion in cash, suggesting he expects better buying opportunities to come.

  • 7 May 2020

The vibe of future returns: tell ‘em they’re dreamin’

It's the vibe, but not much else. Super balance calculations default to earnings rates of 7.5%, but that's in the past. Global experts suggest financial plans are now dreaming at this level.

Baseline outlook for economic recovery is too optimistic

We cannot throw our hands up in the air and say 'this time around, it's simply too hard'. Having no macro view is unhelpful, but many of the baseline scenarios are overly optimistic, says the former CEO of Westpac and now Chairman of Chi-X Australia.

Retiree spending patterns differ from most expectations

A study of actual spending habits shows retirees have a faster-than-expected drop-off in spending in later years, casting doubts on financial plans that assume increasing expenditure over time.

Welcome to Firstlinks Edition 357

There is a remarkable concentration similarity between the Australian and US stock markets that has delivered poor results for Australians and great results for Americans (and global investors). As the share prices of five Australian banks have tanked, the prices of five US technology companies have surged. Each group now represents 20% of their respective indexes, but the journey has been a disaster for many Australians.

  • 13 May 2020

Latest Updates

Economy

Baseline outlook for economic recovery is too optimistic

We cannot throw our hands up in the air and say 'this time around, it's simply too hard'. Having no macro view is unhelpful, but many of the baseline scenarios are overly optimistic, says the former CEO of Westpac and now Chairman of Chi-X Australia.

Strategy

Will our government embrace these three reforms?

COVID-19 is an opportunity for a crucial policy reset, but what does that really mean? Business is hoping for three big reforms, but there are massive barriers to be overcome.

Strategy

8 reasons business has little to learn from 'The Last Dance'

Everyone seems to be watching The Last Dance, a fascinating sports documentary about the pursuit of excellence by one of the greatest athletes of all time. Let's not stretch the business analogy too far.

Investing

Do long-term investors need to care about the ‘next big thing’?

When we look back five years from now, which companies will we regret not having bought at today’s prices? The next opportunities come from focusing on the long term, not the next few months.

Property

Not all non-residential real estate performs the same

Retail assets, particularly those focused on discretionary shopping, will continue to underperform and industrial and logistics assets will be the winners for the foreseeable future.

Economy

The uncertainties of using debt in a time of crisis

The ability of countries to support their economies today turns on fiscal practices set well before this crisis. Increasing levels of debt escalate overall risk, and tie our hands in the future.

Superannuation

Do you qualify for this help in the crisis?

It will surprise many that benefits worth over $8,700 could be available for a couple with a super balance over $4 million. Check if you are eligible for the Commonwealth Seniors Health Card.

Superannuation

What SMSF trustees need to know about benefit payments now

The government has announced initiatives to help people use their superannuation in response to the crisis, but for early access and drawdown changes, there are important rules to follow.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.