The pros and cons of annuities and direct fixed income

Challenger’s Aaron Minney provides his comparison of annuities and direct fixed income in a response to an article recently published in Money Management and authored by fixed income provider FIIG.

Exposure to corporate and government bonds and other fixed income securities can be obtained directly, via a direct bond or fixed income portfolio, or indirectly, via the purchase of either a term or lifetime annuity product.

An annuitant’s exposure to fixed income is indirect because the issuing Australian Prudential Regulation Authority (APRA)-regulated life company is effectively wrapping a very large fixed income portfolio with a contractual guarantee, so it can provide a known, fixed rate of return upfront.

Different levels of income certainty and capital security

An annuity in Australia is a policy issued by a life insurance company. It is a promise to pay a certain amount of money for either:

• A fixed period of time; or
• The remaining life of the policy holder.

APRA regulates the life company and its statutory fund. The statutory fund holds the assets backing the annuity policies and the additional capital required by APRA.

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Policy holders have special statutory protection, based primarily on regulatory supervision of the adequacy of the assets in the statutory fund.

Neither direct fixed income brokers/financial advisers nor the underlying issuers in a direct corporate bond portfolio make any promises as to capital or income certainty.

Hence, a direct portfolio doesn’t need to hold any capital or liquidity buffers.

It is also not subject to prudential oversight, but rather to a much less onerous regime administered by the Australian Securities and Investments Commission that is founded on disclosure, but with few other protections.

The client is more exposed to the performance risk and return of the underlying assets.

Lifetime payment of income and inflation protection 

A direct bond portfolio doesn’t pay you an income for life, no matter how long you live, nor does it carry explicit inflation protection.

Conversely, a lifetime annuity pays out for life and may continue to make payments to a surviving spouse. Typically, annuity payments will increase with inflation to protect against an increase in the cost of living.

Because annuities with a fixed term are more analogous to a direct fixed income investment, the rest of this article will deal with these rather than lifetime annuities.

Risk and return

A central tenet of finance is that risk and return are positively correlated; that is, if you want higher investment returns there is higher risk of capital loss.

A direct portfolio may be higher risk, higher expected return than an annuity, or vice versa, because the investor can select whether or not they invest in high-yielding, riskier ‘junk bonds’ or government bonds with lower returns and lower risks.

An annuity would generally be regarded as lower risk because it provides exposure to a large pool of diversified financial assets through a statutory fund under the supervision of APRA.

These will generally be fixed income assets with a range of credit ratings.

Typically, the average rating will be relatively high (ie, well above BBB) because APRA would require the life company to hold more capital if it chose to invest in riskier assets than these.

In addition, ratings agencies often rate the life insurer providing the annuity, and this rating will reflect the quality of the underlying assets as well as the capital buffers of the issuer itself.

Guarantees and defaults

An annuity policy has a guarantee that is backed by the prudential framework developed and supervised by APRA.

The aim of APRA is to ensure sufficient capital is available to meet obligations to policy holders, even under very unfavourable market events.

These market events include the default risk for each bond in the portfolio as well as market volatility.

Indeed, the regulatory framework expressly contemplates the statutory fund working to protect policy holders in the event of the failure of the life company.

With a bond portfolio, neither the manager, nor the broker, nor the individual companies provide any sort of guarantee that capital or yield will be paid. A direct investor will be subject to losses with any bond that defaults.

Diversification

By virtue of the statutory fund and APRA’s regulatory framework, annuitants are protected by the underlying assets in the life company and are not simply taking single-name credit risk on the issuer.

Buying an annuity policy – like investing in a managed fund – enables a high level of diversification due to the large balance sheet of the issuer.

A direct investor simply cannot match this level of diversification.

Indeed, it is questionable that (even with smaller parcels) many investors would be able to purchase a sufficiently diversified bond portfolio to adequately cover credit and default risk.

Having a single default in a portfolio of 20 bonds would have a large impact on an investor’s portfolio.

Flexibility

For annuitants, the benefits of capital buffers, risk management frameworks, and regulatory-backed guarantees come at a cost of flexibility to change exposures in the underlying portfolio – an option available to direct investors.

Of course, such trading activity also gives risk to transaction costs, including research and execution.

Management time and peace of mind

Direct portfolio investors will need to consume considerably more time managing their investments than an annuitant, who can ‘set and forget’ their guaranteed income investment and spend more time on leisure activities or managing share or property investments.

Also, because an annuity earning rate is fixed up front, annuitants don’t need to worry about the potential impact of economic and market events on the value of their bonds.

These risks are laid off to the life company, which has the expertise, resources and risk management framework to better manage them.

Liquidity

Annuities are purchased for life or for a fixed term – as is the case with bank term deposits – and hence, cannot be described as liquid investments like listed shares or cash.

However, much like term deposits, the annuities’ term can be ‘broken’ early at cost to the investor, and the balance of capital returned.

Direct fixed income investments are generally more liquid than an annuity, but not as liquid as say listed equities.

The capacity to sell a bond will depend on the number of market participants prepared to deal in that security at any particular time.

In the depths of the crisis in 2008, this liquidity dried up completely in some fixed income markets.

Fees

There are no product-related fees payable with respect to annuities (ie, no brokerage, establishment, entry, management or performance fees).

The headline or quoted rate for an annuity is what is actually paid to the policy holder, less fees they’ve agreed to pay their adviser – as is the case with any financial product.

Any costs of the annuity provider, including capital, operating and distribution expenses are covered by the annuity provider out of their margin.

There are no additional fees to the policy holder as long as they maintain the annuity.

By contrast, there are ongoing costs in the management of any direct bond portfolio, which would reduce the net return to the investor, including brokerage fees and transaction costs associated with maturing bonds.

Discussions of the historical and/or expected returns of bonds and bond funds should explicitly detail the costs and provide the after-fee returns so they can be appropriately compared with other fee-free fixed income investments like annuities.

Conclusion

This article has briefly considered the relative merits of purchasing an annuity policy against an alternative of investing in a portfolio of direct fixed income assets. They tend to meet different needs, and both can be used by investors.

For investors who don’t mind paying brokerage and other fees, and have the capability, knowledge and time, a direct bond portfolio can be a way of generating higher returns at higher levels of risk.

For investors who want the security of fixed and guaranteed income, competitive earning rates, and regulatory oversight, an annuity may be the preferred option.

Aaron Minney is head of retirement income research at Challenger.