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Long term annuities

Question from Ross Johnstone

Could we please have informed comment on the (in)security of purchased annuities? It seems to me there is unjustified belief that they are a safe investment for those who seek them, however, nobody can be assured that the many assumptions made by actuaries, auditors and managers of vendor companies will turn out to be correct. They are very risky especially as the payouts will cover many years with many unknowns.

Response from Jeremy Cooper, Chairman, Retirement Income, Challenger

In Australia, annuities can only be issued by life insurance companies that are prudentially supervised by APRA, the Australian Prudential Regulatory Authority.

While no investment is ever completely risk-free, life insurance products, including guaranteed annuities, are highly secure investments because of a robust framework of legislation and prudential standards, an effective and targeted supervisory process and a strengthened and well-resourced regulator with appropriate interventionist powers.

Most recently, these investor safeguards have been supplemented with the introduction of a regulatory capital regime tougher than that imposed in North America and Europe, post GFC.

Capital is the cornerstone of a life company’s strength and the adequacy and sustainability of this capital is the focus of APRA’s regulatory framework. Currently, APRA requires life companies to hold enough capital to withstand a 1 in 200-year shock event, which represents a 99.5% margin of safety over a 12-month period. That is, life companies must keep aside enough capital to withstand the events of the next year with only a 0.5% chance of default.

It is generally accepted that the GFC was around a 1 in 70 year event, and no annuity provider in Australia was required to raise equity capital to achieve regulatory minimums.

So the safety of an annuitant’s claim on the issuing life company does not depend on any assumption by actuaries, auditors or anyone else. The safety for policy holders actually comes from being compulsorily prepared for events to be very wrong (the 1 in 200-year event). When the bad event doesn’t occur, the life company’s shareholders will get a return, and they provide the capital buffer in case it does.

An under-appreciated safety valve for lifetime annuitants is the buffer of shareholder capital that sits between them and the underlying investments of the life company.

The Life Insurance Act 1995 expressly deals with the possibility of failure of the life company by requiring that the premiums paid for annuities and additional capital are ‘ring-fenced’ in a separate account called a ‘statutory fund’ held by the life company. The statutory fund is specifically intended to outlive the life company in the event of it encountering financial difficulties.

When annuities are issued, extra capital must be put in as a buffer to protect policyholders. This capital is provided by the life company (i.e. its own shareholders’ equity) and any claim the life company has on this capital ranks behind the policyholders.

This is a unique feature of annuities: shareholder capital is there to protect policyholders in the event of a fall in the value of the assets backing the annuity.

APRA can even direct a life company to raise more of its own capital to contribute to the statutory fund under expanded powers given to it by legislation in 2010.

If a life company wishes to hold riskier assets than the usual government and investment grade corporate bonds, APRA requires more capital to be held against those assets under its risk-weighted approach. This approach takes into account a range of risk factors that might adversely impact a life company’s ability to meet its obligations and includes: insurance risk (e.g. increasing longevity); asset risk (e.g. adverse market movements); asset concentration risk (e.g. too much exposure to a particular asset or counterparty); and operational risk (e.g. exposure to loss from internal processes or external events). In addition, APRA can impose a ‘supervisory adjustment’ requiring even more capital to be held if it is of the view that there are prudential reasons for doing so.

While necessary to give the complete picture, this discussion of riskier assets is probably misleading. The assets backing annuities are typically conservative: investment grade bonds, high quality property assets with long-term leases to creditworthy tenants and a small amount of infrastructure creating inflation-adjusted cash flows. In fact, the fixed income portfolio of Australia’s leading annuity provider includes more investment grade debt than do the balance sheets of the nation’s big four banks.

Lifetime annuities are by nature long-dated liabilities, allowing a life company to invest in financial assets with long-term cash flows and longer tenor, making them one of the few institutional investors capable of earning duration, or illiquidity premia. These assets are typically held to maturity, so while market movements can impact their market value in the short term, short term fluctuations do not impact the underlying cash flows available to policyholders.

In fact, the short-term fluctuations in the value of assets and liabilities which are sometimes visible through the statutory income statement of life companies are another safeguard for policyholders and demonstrate life companies’ unique position to make and honour very long-term financial promises.

Life companies’ mark to market accounting requirements gives an annuitant better transparency than available to bank term depositors. While a life office must regularly value its financial investments at their fair value, a bank can hold an identical financial asset at par, its purchase price.

In the event that an Australian annuity provider did run into problems due to a market downturn, you could only imagine what a typical 70/30 managed fund/super investment option would look like: burnt toast.

Want to join the debate? Please add your comment on the Cuffelinks website.

Ramani Venkatramani
December 09, 2013

Justin is right to ask about the difference between DB and annuities, and Jeremy is equally correct in pointing out the protection offered by our regulatory regime supervised by APRA.

All long term financial arrangements (annuities, DB, life insurance) are exposed to risk, but safeguards assure a level of protection: no guarantees!

It is not the APRA supervision per se, but the onus on the insurer's board and management (corporate governance, first line of defence) and actuarial advice (subject to professional standards on pain of being disqualified, second line of defence) and whistle blowing (by auditors and actuaries, third line of defence) that underpin our regime's relative robustness. APRA comes later. One does not depend on one's GP primarily for one's wellbeing: healthy habits, controlled eating, exercise, medication... are more important.

The DB regime in Australia is much softer than life insurance regulation and also relative to other countries with DB (eg., the UK). In stress, so far DB has reverted to the dominant DC where available assets underpin member benefits, with no power to require employers to top up, if they had contributed the minimum equivalent to SG (as actuarially certified). 'Stronger Super' (thank you, Jeremy Cooper...) has lifted the benchmark to 'vested benefits' being fully covered, and triggering a solvency remediation regime, if unmet. How this is implemented remains to be watched.

Our annuities regime is quite sound, but it does depend on corporate governance and unbiased actuarial advice. So, assumptions do matter!

Justin Wood
December 11, 2013

Thanks. These are both useful and informative answers. It is good to know that the discount rate for estimating the PV liability is the government bond rate and not some higher rate based on investment return expectations. The 8% pa discount rate used in US Municipal and State DB plans is one reason for the crisis with some plans, such as those in Dettroit and Illinois that are currently in the news. As our retirement system makes more use of guaranteed income streams, developing trust in the providers and regulatory agencies is paramount. Understanding the nuances of discount rates, Statutory capital requirements and stress tests, and the roles played by corporate governance, actuaries, auditors and whistleblowers will help develop this trust.

Jeremy Cooper
December 06, 2013

Justin. Fortunately, our prudential regulation is alive to the scenario you have outlined. Life companies are not allowed to do this. APRA’s prudential standards (which it closely supervises) require that the statutory fund always has sufficient capital to cover all future liabilities discounted using the government bond rate (or something close to this when the maturities don’t match). A life company cannot point to future annuity sales as the source of capital needed to meet those financial obligations. It is a key feature of the APRA framework that it is based around ensuring payments can be made even in run-off, i.e. no inflows.
To zero in on your hypothetical scenario where the life company sells 10,000 annuities a year, it is the sale of the annuities and the investment of the premiums that gives rise to the asset risk charges imposed by APRA. When the annuities are issued, shareholder capital must be injected into the statutory fund and maintained in order to buffer the capital base against credit or market risks.
Once the premiums are invested and the extra regulatory capital is injected, the capital base is then subject to seven separate stress tests designed to protect it from the erosion of value of the assets. Those stress tests are: real interest rates; expected inflation; currency; equity; property; credit spreads and default.
There are numerous other prudential standards relating to solvency, risk management and governance to name a few. Any issues of insufficient capital would be identified by APRA well before any payments are at risk.
You mention fees. Annuities are spread products like bank deposits. There are no fees as such, but an annuity issuer will write annuities at a margin above the swap rate of the tenor matching the annuity. It will then seek to invest the proceeds at a rate of return that ensures a profit for the life company’s shareholders who are providing the risk capital buffering the assets backing the annuities.
Lastly, you make a comparison with defined benefit funds. There is a world of difference between how life companies and defined benefit funds are regulated by APRA. Under SPS 160, for example, where a DB fund’s funding level falls below a satisfactory financial position, it can enter into a restoration plan for up to 3 years in order to restore the funding deficit. This is a much softer regime than where policyholder interests are at stake in a life company.

Justin Wood
December 04, 2013

Do long-term annuities suffer the same risk as Defined Benefit plans - the risk is only evident a long time in the future? That is, when inflows exceed outflows while the fund is growing, payouts are assured and the fund can withstand large adverse events or even malfeasance while still meeting payments. In these early years the fund might report an actuarial shortfall (assets may be lower than the PV of liabilities), but this is critically dependent on the flexibility in actuarial assumptions on the discount rate. To put this in an example: suppose life annuities are being sold for $1 million each to retirees with a promise of $50,000 pa growing with inflation until death. In the early years the fund sells 10,000 annuities each year. In the first year the provider receives$10 billion and pays out $0.5 billion. In the seond year it receives another $10 billion plus the return on the first $10 billion and pays out $1 billion, etc. In the early years there is almost no chance of annuity payments not being made no matter how badly the funds are invested or how large the fees are to the provider. If, or when, the number of annuitants stops growing and maybe even shrinks, the investment returns and fees relative to the annuity promised rate become critical. Do the APRA regulations adequately cover this risk? As indicated at the start of the question, in the past governments and companies seem to have underestimated the difficulty of ensuring DB promises are met without providing taxpayer support.

Ramani Venkatramani
December 02, 2013

Jeremy Cooper's answer that annuities issued by Australian insurers are quite safe is well-argued, highlighting the stronger prudential requirements, APRA's ongoing supervisory process, risk-calibrated approach to refining requirements and the 'ring fencing' of statutory funds.

In doing so, I think Jeremy has gilded the lily a bit, and unnecessarily: it is simply incorrect to claim actuarial assumptions do not affect the security. The 99.5% probability actuaries seek depends on observed past data (subject to smoothing) as well as the collective impact of mortality, investment and expense assumptions relative to actual experience. If this were not so, actuarial expertise would not be mandated (as it now is) in law.

Ring fencing (as in stat funds) prevents annuity-holder funds from cross-subsidising others. The flip side is of course, where a single pool is held on behalf of all claimants (as in banks), the profitability of other operations can and is used to support everyone. The downside of all hedging: while you will not subsidise others, others will not subsidise you either.

Giving APRA powers to ask for more capital is a necessary tool, but let us not pretend that it is sufficient, especially if the provider is unable or unwilling or both. Behind the placid activities of APRA lurk many a moment where owners are asked to capitalise and don't. The reported failures (HIH) as well as the many unreported ones bear testimony.

Operational risk and left field events ('unknown unknowns') remain a residual threat to annuity providers as to all financial intermediaries. Here, regulation is postulated on nothing disastrous happening. Faith-based finance, if you will!

Our annuity system is sound, and balances the competing forces (owners, customers, government) appropriately. But fail-proof it is not. Indeed, 'moral hazard' tells you such a fail-proof system is undesirable and unaffordable.


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