If you’re looking for a way to outsource your investment, longevity and inflation risks, you’re in luck. There is a financial product (a lifetime (indexed) annuity) that allows you to achieve this aim. However, the market for these products in Australia is quite immature, which is not good news for purchasers.
The lifetime annuity market in Australia has been around for many years, yet its size has never been significant. In 2001, 1,927 lifetime annuities were sold for a total value of $166 million. By 2004, this had increased to 2,801 annuities worth $281 million.
However, since then the market has been in decline. In 2007, only 374 lifetime annuities (worth $36 million) were sold by 4 providers (down from 11). This declined even further in 2009, when only 20 lifetime annuities were sold Australia-wide. Around 0.2% of retirement capital is allocated to lifetime annuities.
There has been a concerted effort since the Global Financial Crisis to educate investors about the risks of managing retirement wealth. This has led to an increase in the supply and promotion of lifetime annuities as an alternative risk management tool.
Despite this, the lack of competition within the Australian market is evident and there is anything but a narrow price range for lifetime annuity products. For example, it may cost you up to 35% more capital to get the same retirement income stream from one provider over another.
When compared internationally, Australia is an expensive place to purchase lifetime annuities. A 2006 comparison showed that the cost for purchasing longevity insurance in Australia was almost double that of the US and UK markets. This is probably driven by the lack of available products for hedging the long term liabilities taken on by the provider. It’s also likely to be affected by the uncertainties surrounding mortality risk and the lack of competition amongst providers.
Despite this higher cost, there is a utility based argument that suggests that investors may derive more benefit by outsourcing longevity, inflation and investment risk.
The pricing of Lifetime Annuities in Australia
Annuities are generally considered to be low risk investments, but you shouldn’t think of them as akin to investing in cash. They have more “moving parts” and accordingly their price can vary quite considerably. We’ve been monitoring the price movements of lifetime annuities over the past 6 months and have mapped the average price of comparable offerings. The average price of an inflation adjusted lifetime annuity of $1,000 a year (for a 65 year old couple) is shown in the chart below:
Over this relatively short period, the price variation has been quite high, with the most expensive price ($31,450) being almost 14% higher than the cheapest price ($27,687). That’s a much larger price variation than a low risk cash or bond product.
The cheapest (average) price indicates that a $100,000 p.a. (indexed) income stream would cost around $2.77 million.
We also assessed some relative comparisons to try and uncover the assumptions embedded in the annuity calculations. This revealed some interesting outcomes. We compared the lifetime indexed annuity offerings to the fixed term and non-indexed annuity offerings from the same provider to ascertain the following:
- The (average) break even life expectancy for the last survivor of a 65 year old couple; and
- The (average) inflation expectations built into the indexed options.
Based on our assessments, we found the following:
- On average, the break even life expectancy built into a lifetime annuity product (for a 65 year old couple) is currently around 97 years of age. If the last survivor of a 65 year old couple was to live longer than 97, they would come out ahead on the longevity risk bet; and
- On average, the level of inflation built into the lifetime annuity products is about 3.3% p.a. If you choose an inflation indexed option, be aware that you’re betting that inflation will exceed 3.3% p.a. for the life of the annuity. If it doesn’t, you’d have been better off with a non-inflation indexed option. (Note: The Reserve Bank of Australia aims to manage inflation within a band of between 2.0 and 3.0% p.a.).
Additionally, you have to independently assess the investment return you’ll receive in each offering. This is going to reflect the current low interest rate environment.
While lifetime annuities can help to overcome the uncertainties of retirement planning, the current assumptions used for determining their price mean they’re far from a “lay down misere” as a risk management alternative.
The Lifetime Annuities market needs to develop
We are in favour of a competitive lifetime annuity market in Australia: the attributes of the product carry significant merit for meeting the retirement planning options of Australians. The market, however, is still developing and a co-ordinated effort of both government and institutions is probably required for lifetime annuities to gain broad acceptance. In our opinion, the current market is far from competitive and too thin to offer an attractively priced retirement alternative for most retirees.
Hopefully, the market will mature quickly. However, we don’t see lifetime annuities as the magic cure to the investment world’s ills. It’s unlikely that by simply shifting the risk from one party to another that we’ll overcome the underlying problem of not having saved enough for retirement.