A guarantee for life?

There is no doubt that guaranteed investment products offer a number of features that are attractive for some groups of investors, particularly those with a shorter investment horizon and a limited risk tolerance. In the context of retirement income product and strategies, such products additionally provide a certain level of consistency which significantly reduces the risk of running out of money during this time by providing guaranteed income streams.

However, as with most things, such products come at a cost which is often high as guarantees lack flexibility and tie investors to a given provider for a long period of time, meaning the capital cannot be invested elsewhere and potentially generate higher returns, effectively forcing investors to forego exposure to better incomes.

As always, the additional risk needs to be clearly understood, both on the income and capital side.

ANNUITIES

Annuities are one of the first products that come to everyone’s mind in the discussion on the guarantees and they can be only provided by a limited number of issuers in the

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Australian market, such as insurance companies, which are regulated by the Australian Prudential Regulation Authority (APRA). Additionally, annuities come with a capital cost associated and a number of regulatory requirements under which insurers are obliged to keep a certain amount of capital allocated to those products. 

“This is called reserving and means there are certain requirements around the type of assets that can be held in the reserve, and how the value of the assets has to be greater than the value of the liabilities, so there is definitely a capital cost associated with these types of products and that can be quite constraining for the issuers,” Richard Dinham, head of client solutions and retirement at Fidelity International, said.

According to Ashton Jones, head of investments, retirement and new propositions at TAL, it is also important that investors have a clear understanding about fully guaranteed products and their specific attributes. 

“If the consumer is purchasing the annuity to ensure that they will get a level of income regardless of what happens it could be entirely suitable for that individual. But there is still the role for traditional annuities in the current interest rate environment and it is important to understand that annuities are very sensitive to the current interest rate environment, because they do require the underlying investment to match the income stream payment that has been provided,” he added.

“The main focus and work that we do at TAL in terms of guarantees is in the context of retirement income products. That is mainly where we are interested in roles that guarantees can play and one of the things we know around the work that we have done with our superannuation fund partners is there are some members who value the level of certainty in their retirement income.

“So what we have been focused on with our super fund partners is exploring is there a better way and better value that you can provide, to members or customers, by unbundling annuities and looking at those three different [types of] guarantees.”

Typically there are three types of the guarantees within a product like that, including a longevity guarantee, an investment performance guarantee, and for some products, an inflation-protection guarantee.

According to Bennelong Funds Management’s director, research relationships, Stuart Fechner, investors should pay close attention to who is providing the guarantee and its related structure.  

“Should circumstances dictate that the guarantee is needed, you want to make sure that the company or provider behind it is in a strong financial and well capitalised position to meet this obligation, if this is what is required,” he said.

“Otherwise if it is more about the structure and operational workings of the guarantee, what happens – is there a trade-off to any other aspect of the product if the guarantee process needs to be enacted. An example might be that if the guarantee needs to kick in to provide the stated level of income, does it in any way impact where the capital itself is invested and/or the potential upside and growth in capital that can be achieved?

“There has been huge demand for products like these from investors and advisers and a strong interest from product providers and it has probably been a challenge or a focus ever since the baby boomers entered the retirement because there is a huge market with lots of opportunities. But I do not think anyone has nailed the solution as yet and that really comes back to that fundamental of risk returns and being on that risk spectrum,” Fechner said.

There are also five-year or 10-year guarantees, which are not dependent on life expectancy, and which offer the returns that are typically better than the lifetime annuities.

“From a financial planning perspective they have much more appeal because they provide certainty around the amount of income and investors have certain income needs regarding their lifestyle so they can allocate a certain amount of their capital to that, and invest the rest in more risky assets that can be more volatile but hopefully produce higher returns over time,” Dinham said.

IS IT WORTH IT?

Guarantees are also often perceived in a way similar to insurance products by consumers who agree to pay an often higher than average fee for protection during more volatile times.

“I think the most important point to understand is that guarantee products historically required the issuer of the product to hold quite a lot of capital against the guarantee, and typically that capital needs to be invested in a way to match the profile of the payments the product is making, and when interest rates are low it makes it often quite challenging for providers to be able to find appropriate asset classes to match that income streams against,” Jones warned.

AMP’s platform and retirement income specialist, Ian Parsons, said: “The key risk is if you fundamentally believe that the market will go up and there will be no downturns, then you are paying for something that potentially has no value”.

However, he warned, during the difficult times, like the Global Financial Crisis (GFC) or more recently during the COVID-19 pandemic, guarantees mean that in the worst-case scenario investors will still receive their money back. 

“The primary thing that we are trying to address with our product [MyNorth Guarantees] is understanding the sequence risk and the sequence of returns that will have a large impact on clients, because they do not have necessary time anymore when they are moving into a retirement phase and start to cool down,” Parsons explained.

“What we are trying to do there is to say if we can guarantee a portion of the client’s account, we can guarantee the amount of money that could give them confidence which leads us to the second part of the conversation which is giving them the confidence to remain invested, knowing that there is a downside protection.

“I think one of the things that we saw during COVID-19 is that there are definitely certain members that do find market volatility quite challenging and they find it very difficult to experience and what you typically see in that sort of market environment is consumers do often make very short-term decisions,” TAL’s head of investments reminded.

According to him, the falling account balances triggered some members to take action to stop the pain of those market losses. However, although COVID-19 brought significant volatility to the markets, many of the growth assets have largely recovered since then.

“So, for any member that sold out at the start of COVID-19 and invested in the asset class that did not have that much growth exposure, it was probably a tough decision to make at the time and it was probably not the best decision.”

Jones said that the best way for investors and clients to think about guaranteed retirement income strategies would be as something that would provide ‘quite a nice flow’, to the level of retirement income to be received.

“And what that does is, it gives members more confidence to take a level of investment risk in the remainder of their portfolio because they know that, even if there is volatility, they still have that portion of account balance that is invested in a product that is going to give them a level of retirement income no matter what happens.”

According to Jones, it all comes down to work out which guarantees consumers value the most.

“What we have found through that is, there is definitely a section of members that really do value the longevity guarantee so that’s the confidence that they would get income for the rest of their lives no matter what the experience is,” he said. 

“But those members, they also want to benefit from the higher long-term growth of the assets that they have invested in the annuity products. Those are the sort of products that we would call investment-linked annuity or a variable-style annuity, so that’s sort of the product design that we’ve been exploring with the some of our fund partners,” he said.