The value of guaranteed lifetime income
Jeremy Cooper looks at what advisers should be considering following the latest changes to the Age Pension.
The latest changes to the Age Pension thresholds and taper rate are designed to reduce the long-term cost to the taxpayer, mainly by reducing the number of Australian retirees getting the full Age Pension.
In light of all the benefits of the Age Pension, the question those affected are likely to be asking advisers is: “How can I create a ‘no ifs or buts’ stream of income to make up the difference?”.
Let’s start with what you are trying to replace. If the Age Pension were a standalone financial product, it would look like the gold standard income stream. It is a fortnightly payment of a known amount, effectively AAA-rated and it adjusts for inflation and other factors to maintain your purchasing power.
It’s simple enough to draw down on more super to replace the missing cashflow, but the Age Pension is more than just a handful of dollars. It is also a promise that regular and stable income will continue for life with all risks managed.
The gold standard comes from the peace of mind of knowing exactly what the payments will be and that they will keep coming; no ifs or buts.
It is the certainty of an Age Pension payment that is the hardest thing to replicate. While there are many benefits to account-based pensions, retirees often can’t figure out what they are actually spending when they draw on them.
Are they spending solely income or are they spending capital or a bit of both? With the Age Pension, the payment is unambiguously earmarked for consumption. It is not a blend of anything. It is for spending and so the sustainability of the rest of your retirement portfolio is not affected.
This is what a lot of clients will be looking for when they ask about topping up their fortnightly Age Pension payments. In the defensive part of the portfolio, which is where the Age Pension sits, clients want a very high level of certainty about their spendable cash flows. There is room for risk and growth assets in most retiree portfolios, but not when it comes to meeting essential spending needs.
More retirees seeking guaranteed income
This can be seen in the record sales of lifetime annuities in the Australian market. Data is not available for the December quarter yet, but according to actuaries and researchers at Strategic Insight, the first three-quarters of 2016 almost reached the record sales achieved for the whole of 2014.
Why would someone consider a guaranteed income as part of their retirement income plan? A lifetime annuity is a unique proposition.
It is a financial instrument that lasts for exactly the length of your life. Well known studies have shown that once you retire, you become as much as six times more risk averse than someone in the workforce.
Having part of your retirement income guaranteed for life addresses the strong aversion retirees have to losing money.
An alternative approach is to chase higher returns, expecting that the capital will last as long as the retiree lives. However, those returns can be volatile and are not guaranteed.
So those who value the guarantee will accept the potentially lower return on this part of their portfolio.
The popularity of term deposits (TDs) also illustrates this preference, but TDs do not help with longevity risk and the retiree is left to judge how much they can safely spend. The lifetime annuity takes care of both.
A guaranteed lifetime income suits people who have sufficient savings to not be solely reliant on the Age Pension, but still run the risk of outliving their savings.
Those with minimal retirement savings or with very substantial levels of retirement wealth might be less likely to benefit from the longevity risk insurance an annuity provides.
Some advisers will ask whether it is a good time to buy a lifetime annuity in the current low interest rate environment. A question like this is usually asked in the investment frame.
Investment returns are important, but they are not the whole story. For a start, when thinking about a guaranteed lifetime income, you are in the defensive, rather than the returns-seeking or growth part of the portfolio.
Your reference point should therefore be bond-like returns, not higher risk equity-like returns.
The proposition advisers are considering for a client involves a consumption element: the exchange of capital for regular, dependable cash flows and insurance against outliving their savings.
The number of payments they will receive is pegged to their actual lifespan, whatever that turns out to be. If they live longer than average (as roughly half the population will) they will be enjoying the insurance feature of a lifetime annuity.
This has an insurance value not immediately recognisable by just looking at the headline rate of return.
Australia’s super system is now delivering more retiree households in this middle category. There are now more people retiring with more wealth (in superannuation) who value guaranteed income above their Age Pension entitlement.
As 2017 progresses, industry stakeholders will ponder the design of the proposed MyRetirement framework and the products that will facilitate its success.
In this process, the role of guaranteed lifetime retirement income should not be overlooked. For MyRetirement to succeed, there will need to be a range of products and providers, including a central place for solutions that remove the key risks facing retirees altogether.
Jeremy Cooper is the chairman for retirement income at Challenger.
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