Deferred lifetime annuities – a solution or an expensive waste of time?

SMSF technical expert and columnist for The Australian newspaper
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Genuine long-term deferred annuities are now government policy.

I think this policy is unnecessary for most investors. I’ll explain why in a moment. First some background.

Annuities “101”

All annuities have to be provided by life insurance companies and are designed to pay you an income – at least annually. Some pay for a defined period of time (typically called ‘term’ annuities). Other annuities pay for the rest of your life, or the life of your reversionary annuitant, if you have nominated one. These are called ‘lifetime’ annuities.

Built into these products are adviser remuneration, as well as life office expenses and a profit margin.

They’re reasonably complex, inflexible and costly products and it’s almost impossible to work out what’s going on inside them.

All annuities in Australia are ‘immediate’ annuities, that is, they begin paying you an income as soon as the life insurance contract is finalised.

A ‘deferred’ annuity follows these broad principles but begins to pay you an income each year after a pre-set period of time. These types of annuities were quite common for many years in Australia before about 2000. In the mid-80s, the Government mandated that income payments from these products had to commence when the annuitant turned age 65 (there were some exemptions and exceptions to these rules).

The government is now contemplating allowing you to purchase a deferred annuity and permit a long time period before income will have to be paid, e.g. 20 or 30 years into the future.

Managing longevity risk

The stated purpose of these products is to help retirees manage longevity risk. This risk is a fancy way of saying that you’ll run out of retirement savings before you die.

Longevity risk arises for two principal reasons:

  1. Before retirement, investors underestimate their living expenses and haven’t saved enough; or
  2. Many market-linked pension and annuity products force you to constantly buy and sell assets to deliver you an income.

All retirees need to very accurately and very carefully estimate how much their living costs will be in retirement. Moreover, this financial budget needs to be continuously monitored and adjusted as circumstances change – for example, costs increase because of tax changes or general consumer inflation.

All asset prices move around constantly and unpredictably. More to the point, it’s impossible to control the movement of these prices. This means that if you have to “sell” units or assets at prevailing market prices to receive an income, then there’s a good chance you’ll go broke, because the amount of capital you need to expend on each and every income payment is at the mercy of the market price of an asset.

Last week, I gave the following example to illustrate this problem – an investor puts $200,000 into a managed fund that has a $1.00 unit price, which means they “own” 200,000 units. Suppose that after several years, the unit price has increased to $2. Their 200,000 units are worth $400,000. If the investor wanted to pay themselves $20,000 income from this fund, they would need to sell 10,000 units while the unit price is $2.

Now suppose that the price of the units has crashed to 75 cents, but they still wish to pay themselves $20,000 income. They now need to sell 26,666.66 units. Under this second scenario, units are walking out the door as income.

So for $40,000 of income, they have used up 18% of their units for two years’ income. Somehow, miraculously, their units are meant to last for at least 20 years.

These aren’t extreme examples of unit price movements – I have seen unit price falls emasculate retiree money in 1994, 2001, 2004 and 2007.

For someone receiving monthly income payments over 20 years, his or her income is determined by 240 different market movements. I think this is madness on a grand scale.

There is a better way to manage longevity risk

The key to solving longevity risk isn’t deferred annuities. In reality, there are two solutions.

Firstly, invest your assets to earn income and live off that income. You should find investments that pay an increasing level of income to take into account inflation.

You should only be looking to sell assets so you can move from one income-paying asset to another income paying asset.

It’s true that the income you’ll receive from investments fluctuates, but it doesn’t do this as often or as sharply as the market movement of asset prices. In fact, there are a number of “blue chip” shares that have stable (and generally increasing) dividend payments – while the share price moves up and down, the dividend is far less volatile.

Some people find that living off the income their assets generate is insufficient because their assets don’t generate enough income to cover their lifestyle. There are no simple solutions to this problem, except to either work until your retirement assets can generate the income you need for your lifestyle, or readjust your retirement lifestyle expectations.

The second solution to longevity risk is to reduce the cost of advice and administration of your retirement investments. Even a 1% per annum reduction in fees will make a significant difference to your retirement income earning prospects.

In short, I believe the solution to longevity risk isn’t traditional, expensive and inflexible annuity products. The solution is to simplify how you invest your retirement money, invest to earn inflation-linked income and keep your fees to a minimum.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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