(03) 9020 2905PORTFOLIO POINT: How can you assure an income stream above the government age pension for life? With an annuity. And they’re back on the agenda.
Superannuation annuities became as popular as the browning bananas in the fruit bowl. You know they’ve been there for ages. You know they’ve got a use. But who wants them unless you’re making a banana cake?
However, annuities are likely to make a comeback (as Robert Gottliebsen pointed out recently in Annuities look good again). Investor and SMSF trustee fear will drive a part of that – retirees have watched large chunks of their retirement lump sum disappear and locking in the surety of some sort of an income stream might be too tempting.
In some ways, the timing couldn’t be worse. The best time to have been signing up for an annuity was when no-one was interested in doing so – when the market was at its peak. Locking in an income stream in 2007 would have been to have taken your income stream based on asset prices at the top of the market and the annuity provider would have been wearing the risk of the market fall. Clearly, it’s better than locking in at the bottom, which could be quite costly. It’s another argument in favour of being counter-cyclical.
Lifetime annuities are about transferring longevity risk – the risk that you’ll outlive your money. You come to an agreement with an annuity provider on a defined payment to be made indefinitely. If you live too long, the provider will be out of pocket. The risks for the investor are, in part, dying too soon. In that case, your beneficiaries might be worse off.
However, it’s possible that annuities may also get pushed down the throats of retirees by a government looking to continue with long-term restructuring of Australia’s retirement income streams policies. That is, just when you’re supposed to get access to your superannuation, you could be forced to lock a portion of it away as a lifetime income stream.
Unrealistic? Not really. As we’ve seen again recently, governments can’t help themselves when it comes to superannuation. Just when you’re getting used to a system, they’ll change it, just because they can. We saw this in May with the reduction in the concessional contributions limits in this May’s federal budget.
But even more importantly, Treasury is actively trying to reduce the long-term pressure on the Federal Budget with a plan to raise the access age for the government pension from 65 to 67. There’s persistent talk the current or a future government will do something similar and raise the age for access to superannuation, which is currently a maximum of 65.
And a recent proposal put to Ken Henry’s tax review from fund manager Challenger might show the sort of way forward that the government could consider. Particularly when they couch it to Ken Henry that their plan will not only deliver higher retirement incomes, but save the government a few bucks on the age pension also. Challenger’s modelling believes a lifetime annuity stream system could save up to about 5% of the actual cost of the age pension to the government.
Challenger’s argument is that legislated and more creative use of annuities could guarantee, for life, that a retiree will get to live on more than the safety net government age pension. Lifetime annuities are one way of insuring against longevity risk. They can insure that your super doesn’t run out before you expire.
Broadly, Challenger’s submission to the Henry review makes two interesting recommendations for annuities from a Federal budgetary perspective. But they are also of interest to SMSF trustees (and generally super fund members) looking at their wider options.
SMSF trustees should keep an eye on this space. For SMSF trustees, being told what you must do with a portion of your super means a loss of control. But for a government concerned about the risks to its bottom line from an ageing population, legislation in this area has some real potential upsides that might be too difficult for them to ignore.
The first of Challenger’s proposals is for governments to force retirees to take a fixed portion of their superannuation as an immediate lifetime annuity. The second kite being flown is to force retirees to take a deferred lifetime annuity (that is, one that starts at some nominated time in the future), which would cut in at around the time of life expectancy (so around 80) and would clearly insure against longevity risk. For the investor, an annuity is akin to an insurance premium. You pay a lump sum to an annuity provider and in return to get peace of mind.
Challenger argues that a compulsory system of annuities is simply a logical and reaffirming extension of the principles of Australia’s compulsory superannuation system. That is, the whole 20-year-old superannuation guarantee project has been about delivering higher retirement incomes for the nation.
One of the problems facing Australia now is that there is no restriction on drawing your super once you’ve turned 65. There is little stopping you blowing your super and then signing up for the government age pension the following day.
Challenger argues that lifetime annuities used to fix individual incomes at a higher level than the age pension would also: limit the government’s exposure to longevity risk; put less pressure on major increases to the age pension in the future; and, by reducing future budget pressure, it could allow the government to give lower paid workers more incentive to save for their own retirements.
At the moment, Challenger’s submission argues, there is also an inherent bias in lifetime annuity products that continues to make them unattractive to the majority. They tend to be taken out by those who believe they have good genes that will see them live longer to get the most out of the “lifetime” aspect of the deal. This affects the pricing and returns on the products and means that those who have only “average” mortality rates end up with returns that are unattractive. If it were compulsory, lower risks for the annuity provider (those who were likely to die earlier) would be thrown in with higher risks (those who should live longer) and overall risk would be reduced and pricing would improve as a result.
So, what would Challenger’s proposal have us do?
If a person reached their preservation age of 65 with $500,000 in super, $150,000 would be compulsorily put towards a lifetime annuity. Assuming an interest rate of 5% (as a longer term average rather than what is achievable now), this would provide a lifetime annuity of approximately $13,000 to $14,000, rising with inflation, for life. The remaining $350,000 would stay in the current environment.
While the account-based pension scheme took a strangle hold from its inception, because of its relative simplicity and affordability (the fees are considerably lower), super members should keep abreast of any government intention to move annuities back into the mainstream, particularly from a government that has already shown a willingness for progression towards a more sustainable system.
Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.