The Government has given the moribund Australian annuities market a new shot of life with a long-called-for tax break.
Deferred lifetime annuities and group annuity products will begin receiving the same tax exemption on earnings as account-based pensions from July 1, 2017.
It won’t be enough and parts of the financial services industry are likely to push for even stronger legislation to compel investors to annuitise their retirement savings.
It may superficially fit with the government’s new objective for superannuation – to provide income in retirement to substitute or supplement the age pension – but annuities remain a product-led solution which will need a major overhaul if they are to match the behavioural tendencies of investors.
Retirees already use their money responsibly
Super often ends up as a retiree’s second largest asset, after the family home, thanks to a lifetime in the workforce. It is a substantial asset which the bulk of retirees already prefer to draw down as regular income.
Less than 30 per cent of super benefits are taken as lump sums according to last year’s Productivity Commission report into superannuation policy for post-retirement. Meanwhile, the bulk of those who do take lump sums, use the money to sensibly pay off debt, such as a mortgage, or to invest, according to the report.
However, the bulk of retirees drawing post-retirement income do so via an account-based pension, which imposes minimum drawdown rates but still allows the freedom to withdraw lump sums. This flexibility is crucial to pay for significant one-off medical expenses or nursing homes, as retirees get older.
Unfortunately account-based pension investors are still exposed to longevity risk – the chance they will outlive their savings – so many choose to effectively self-insure by drawing down the legislated minimum amount.
A 60 year-old with a $200,000 super drawing down at the minimum rate (and assuming 6 per cent annual returns) will end up with a final account balance of approximately 25 per cent of their initial amount at death, according to a treasury’s retirement income streams review released in May.
Products such as deferred lifetime or pooled annuities can potentially provide guaranteed income levels until death. So why do they remain so unpopular and why does the industry still want retirees to buy them?
Post-retirement innovation misses the behavioural mark
A significant number of longevity products have been launched in recent years by major companies.
These have included lifetime annuities, fixed and variable annuities, and pooled longevity funds (or tontines). Other post-retirement investment options to hit the market include risk-managed and income-focused investments, lifecycle funds, and bucket strategies.
Investors have had logical reasons for turning their back on many of these annuity products. They naturally take away the flexibility investors want, in order to provide greater income certainty. Many annuity products are also complex and expensive given current low interest rates.
While the new tax exemption will result in another burst of annuity products onto the market, they will still need to overcome the biggest hurdle holding back their widespread adoption: innate investor behavioural biases.
The key challenge is most investors’ inability to make rational decisions when the ultimate benefit isn’t received for many years – a bias known as hyperbolic discounting.
It is a major detriment for products such as deferred lifetime annuities, where the initial payment does not begin until 20 years after retirement.
The UK experience stands as a prime example.
Investments in UK annuities plummeted after the government announced that it would scrap its compulsory annuities policy in 2014. Between July and September 2015, just 13 per cent of 178,990 new pensions were used to buy an annuity, according to a report by the Financial Conduct Authority.
More options to manage longevity risk
Longevity risk is rising as Australia’s population ages. Most current and impending retirees can expect to spend five to seven years longer in retirement than their parents’ or grandparents’ generation, according to the Productivity Commission report.
But the guaranteed income provided by annuities is just one solution to this growing problem.
Longevity risk is also dependent on a range of other factors including the rate of investment returns, the rate of inflation which affects real returns, and the spending behaviour of retirees. More legislation could also be tweaked to improve the standard of living for retirees. Encouraging retirees to unlock the value of the family home (which sits outside the age pension means test) is the most obvious policy setting.
However, annuities remain the financial services industry’s simple and preferred solution.
The industry will need to be extremely judicious as it begins designing comprehensive income products for retirement (CIPR) – the government’s new default post-retirement options for those retirees who don’t make an active choice.
The default accumulation ‘set and forget’ mentality just won’t work for retirees.
Investors naturally have high levels of financial engagement as they approach retirement and the industry can tap into this with quality financial advice. When necessary, retirees can be nudged towards more rational decisions which suit their personal circumstances.
Rather than mandate or strong-arm investors into products such as deferred lifetime annuities or pooled products, a wiser method is to take a holistic approach which embraces all of these factors.
