Annuities the natural retirement default?
Mike Taylor writes that while other options may exist, annuitisation has become the preferred foundation for the development of Government approved retirement income products in Australia.
The Federal Treasury is still working its way through industry responses to its discussion paper on the ‘Development of the framework for Comprehensive Income Products for Retirement (CIPRs)’ but at its core it represents a discussion about how pooled products, typically annuities, can best meet the needs of Australian retirees.
There is a range of retirement income products utilised in the US, the UK and elsewhere but in Australia it has become obvious that annuitisation will form the bedrock of the Government’s approach to what might ultimately emerge as a default ‘MyPension’ product.
When the Government used its 2016/17 Budget to announce its intention to remove many of the tax and other barriers to the development of retirement income products it did not so much represent a green light for the industry to embark on some serious product development but, rather, a confirmation of the need to progress an issue which had been on the industry’s agenda for most of the past decade.
While the Government’s discussion paper was released only in December, last year, the industry had been seriously modelling outcomes at least four years’ prior to that and concluding, on the same basis as the Government, that pooled arrangements represented the best option.
The Association of Superannuation Funds of Australia (ASFA) director of research, Ross Clare published a comprehensive analysis in October 2013 in which he stated that, while a variety of financial products could be used to deliver an income stream in retirement, ASFA had chosen to focus “on those that involve some sort of guarantee in terms of income-stream payments for individuals who reach an advanced age”.
Clare noted that there were a number of financial products which explicitly dealt with the financial consequences of longevity and that these included “deferred annuities” and “variable annuities”. He defined deferred annuities as follows:
“A deferred annuity is a type of annuity contract that delays payments of income, instalments or a lump sum until the investor elects to receive them.”
Clare then defined variable annuities as follows:
“A variable annuity is purchased with either a lump sum or over time, with the premiums paid allocated among the various separate account funds offered in the annuity contract. The investment return and income paid by the variable annuity fluctuates with the performance of the underlying investments. However, in return for a fee, the provider of such products may guarantee a minimum payment, either for a set period or for life. The more the guarantees, the higher the fees paid.”
The ASFA director of research then made the point that while both variable and deferred annuities had been popular overseas, including in the US, Asia, and Europe, Australia had experienced much more limited exposure with only one or two providers of variable annuities.
“Deferred annuities have not really been on offer in Australia or purchased to any marked extent,” Clare’s analysis said, noting that while a lack of demand for annuity products (with the recent exception of term annuities) had been partly responsible for this, regulatory, and tax settings had also contributed to the outcome.
The 2013 ASFA paper then went on to itemise the changes to the tax settings which would be necessary to see the greater take-up of annuities-type products many of which were then reflected in the proposed legislative changes which flowed from the Government’s 2016/17 Budget announcement.
The Government’s rationale
The driving force behind the Government’s 2016/17 Budget announcement was the harsh reality driven home by the successive Treasury Intergenerational Reports which pointed to increasing heavy reliance on the Age Pension as Australians live longer and actually outlive their superannuation accumulations.
The Treasury discussion paper issued in December 2016 pointed to the limitations of people drawing down on their super balances in the form of an account-based pension and just how quickly they would likely find themselves relying on the Age Pension.
“Individuals with an account-based pension can choose the level of drawdown (at or above legislated minimum rates). However, drawing income above the minimum rates causes individuals to face an increased risk of outliving their superannuation savings,” the discussion paper said adding that, “this is a trade-off most individuals are unwilling to make: a majority of individuals draw down account-based pensions at or close to the minimum rates”.
However, it pointed out that drawing down an account-based pension at minimum rates reduced the risk of outliving one’s super wealth, but it also reduced the standard of living that individuals could enjoy in retirement.
“In addition, it implies that a substantial percentage of superannuation assets is expected to be bequeathed rather than used as income during retirement,” it said. “By managing their superannuation assets in this way, individuals are self-insuring against longevity risk, which is an expensive way of managing this risk (measured in terms of forgone income).”
“It means that individuals in retirement are drawing a lower rate of income so assets will last for the longest possible lifespan (potentially 40 years).”
The discussion paper then suggested that: “alternatively, products that pool longevity risk could potentially provide higher levels of income (all else equal), because they are priced to draw down assets over the life expectancy of the pool (typically closer to 20 years)”.
The chart below shows that, in an account-based pension, if an individual chooses to draw down their superannuation at a faster rate, they can increase their income (moving from point ‘A’ to point ‘B’), but the risk of outliving their savings also increases.
The Treasury discussion paper said there was also a lack of choice for individuals who were looking for an alternative retirement income option in Australia that better met their needs.
“Australia has an under developed retirement income stream market, with at least 94 per cent of pension assets in account based pensions,” it said. Despite significant heterogeneity among retirees, almost all Australian retirees choose a standard account-based pension as their retirement income product.”
What the Government has proposed
The Government’s discussion paper around the development of comprehensive income products in retirement (CIPRs) states that it is “proposed that trustees be able to offer to their members at retirement a mass-customised CIPR as the retirement income product that is suitable for the majority of members of the fund”.
It suggests that this will “present individuals with an anchor or starting point for the retirement income product decision”.
“Having made the decision to retire and upon being presented with a CIPR as an option, members would need to make an active decision to commence the CIPR, or they may choose to take their retirement benefits another way (including, where available, by taking the CIPR offered by the trustee and adjusting the composition of the underlying products to meet their individual circumstances).”
The discussion paper said the proposed choice architecture was predicated on the fact that, generally, individuals were likely to be better off in retirement when allocating a percentage of their superannuation balance to a longevity risk management product than if they did not.
“Secondly, while there are differences between individuals at retirement, in one sense all retirees are homogenous in the important respect that they do not know when they are going to die and must manage their longevity risk. This is the case whether an individual has a short or long life expectancy (except for those with a terminal illness).
The discussion paper said that providing members with a guided choice upon retirement also sought to address the problem that individuals were facing complex financial decisions, a lack of guidance, and behavioural biases at retirement.
“Behavioural research and experience overseas indicates that a ‘default’ has a very good chance of being selected by individuals, given the prevalence of status quo bias,” it said.
“Under the CIPR framework, the trustee would design the CIPR so that the member receives a broadly constant income stream for life. This contrasts with the status quo of drawing down account based pensions where members can elect to drawdown income based on the government prescribed minimum drawdown rates or can choose an alternative (higher) draw down rate. Therefore, a CIPR could reduce the decision-burden for individuals, and would provide a greater role for trustees to guide their members.
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