Pension for life?

Some would expect that caution following the global financial crisis may have stifled financial product innovation, but the industry is set to pander to the needs of those nearing retirement who, struck hardest by the economic downturn, need better solutions and fast.

Driven by consumer need, product providers are looking to up their game in the provision of retirement solutions.

Much of the tweaking around retirement income services and products relates to superannuation. A number of companies are offering services around consolidating super to help investors make savings on fees, and super funds are improving their service proposition through offering cost-effective life and total permanent disability (TPD) insurance.

Some would argue that the recent decision by the Australian Securities and Investments Commission (ASIC) to enable super funds to provide members with limited personal advice also enhances their service proposition, giving more people access to advice they would not otherwise be able to afford.

However, the issue of concern is not so much at the accumulation phase, but rather at the transition to retirement phase.

According to an OECD (Organisation for Economic Co-operation and Development) report, ‘Pensions at a glance 2009: Retirement-income systems in OECD countries’, workers close to retirement “are the group most acutely affected by both the economic and the financial crisis”.

Thanks to the compulsory super system, Australia has a good track record at saving for retirement. However, the global financial crisis and the subsequent losses experienced have left many close to retirement in a precarious situation, as they have little time to recoup those losses.

And as most Australians continue to take out pensions as lump sums to invest, or as income streams, the value of their retirement assets are vulnerable to financial market volatility.

“I think the issue is not one of how much we save, but how we structure our investment portfolio in retirement,” said Challenger Financial Services chief investment officer, asset management, Richard Howes.

“The focus is not enough on longevity protection and market risk protection in retirement, which are the two biggest issues that retirees face at the moment,” he said.

CommInsure general manager of product management, Clive Levinthal, said there are no longevity protection products available in the market.

“We know Australia has done a reasonable job in terms of sorting out the retirement crisis in terms of the accumulation phase. But in terms of the drawdown phase, there is still work to be done,” he said.

“There are a lot of people in the community that believe some kind of longevity protection is required.”

Pre-retirees affected by the severe market downturn have some difficult choices: either work longer, purchase annuities, purchase longevity insurance (which acts as a deferred annuity), access home equity through products such as reverse mortgages, or revert to Government assistance through the age pension.

The final option is a matter of last resort, but too many people end up relying on the age pension because of poor retirement planning as their savings fall way short of expectations.

Research has shown that Australia is uniquely over-exposed to risky assets, and in the past year an estimated $200 billion has been wiped off superannuation balances.

The OECD report revealed that Australia’s superannuation funds experienced real losses of 26.7 per cent in 2008.

Compared to the 30 other OECD countries studied, this is the second worst investment performance for private pensions.

The report found that the impact on Australia was significant firstly because private pensions and other investments provide 45 per cent of retirement incomes in Australia (more than double the OECD average of 20 per cent) and, secondly, because of the large share of equities in pension fund portfolios, which was around 57 per cent before the start of the crisis (compared to an average of 36 per cent in the 20 OECD countries where this type of data was available).

The report stated that while some older workers switch to less risky investments as they near retirement, in Australia more than 60 per cent of people stick with the default investment options of their private plan, and equities typically make up around 60 per cent of this portfolio.

Add to this a general apathy towards longevity risk, and the need for the industry and Government to address longevity risk becomes more important than ever.

Compulsory annuitisation

A World Bank research paper issued in October last year, entitled ‘The market for retirement products in Australia’, revealed that Australians are generally not significantly concerned about longevity risk. This attitude must change if people want a standard of living well above that afforded by the age pension.

According to the OECD ‘Pensions at a glance’ report, nearly 27 per cent of over 65s in Australia have incomes below the OECD poverty threshold.

“Of all the OECD countries, Australia has the third most pensioners living beneath the poverty line,” Howes said.

“I don’t think there is a perception amongst people that the age pension is enough. I think there are certain behavioural vices that tend to mean that investors don’t consider very long-term outcomes, including those to do with their own longevity. Which is why a system of either compulsion or high incentives for longevity protection are the way forward.”

As part of its submission to the Henry Tax Review, Challenger proposed that people be compelled to direct a portion of retirement savings (a suggested 30 per cent) moving into the benefit phase towards either an immediate or deferred annuity.

According to research commissioned by Challenger, the long-term implications for the Government’s Budget should this compulsion be adopted is that it would reduce total age pension costs by up to 5 per cent.

Howes said this not only addresses Government budgetary constraints by ensuring less reliance on the age pension, but it also addresses the issues of market and longevity risk.

The Challenger submission stated that advantages of compulsion would include:

• through pooling of life risk, life offices will be able to offer less costly cover for longevity risk for retirees who would otherwise self-insure;
• annuities are guaranteed by the provider who accepts downside market risk;
• indexed annuities can be used to address inflation risk;
• annuities control the rate of drawing whereas higher early drawings permitted by alternative products providing equivalent returns reduce future earnings and therefore income over remaining life;
• life-time annuities guarantee an income in excess of the age pension over the full course of retirement; and
• annuitisation of a proportion of retirement savings can be used to ensure an appropriate weighting of defensive assets in portfolio asset allocation.

The compulsory superannuation system is aimed at ensuring retirees are self-sufficient throughout their golden years, with the age pension serving as a safety net.

However, the Government’s laissez-faire attitude towards superannuation at the benefits phase means that people can pretty much do whatever they want with their super on reaching retirement age. There remains a high proportion of people who take their super as a lump sum as opposed to a pension (55 per cent according to the World Bank paper).

If you were to assume that many people do not consult a financial planner and most do not have the requisite knowledge to invest their savings appropriately to ensure they achieve an adequate income stream until the end of their days, the likelihood of them at some point relying on the age pension increases. Again, the argument for some sort of compulsion around annuities is enhanced.

“We think compulsion would be the most effective way,” Howes said.

“We note that the entire superannuation industry is built on the concept of compulsion … So relative to that type of compulsion that has had very good public policy outcomes, we feel that compulsion in retirement, which would generate less risky outcomes for retirees, would generate results where they’re protecting their longevity exposure, and would reduce instances where people are running out of money well before they meet all their plans.”

However, many people have an aversion to lifetime annuities for various reasons, both financially and emotionally.

Annuities are costly, and the asset test exemption for long-term annuities has been removed from September 2007. Annuity products leave little or no residual value, so the risk is that the retiree will die early of expectations without the ability to leave a bequest.

On the other hand, account-based pensions have various tax advantages, there is the possibility of leaving behind a residual sum, and the retiree has control over the portfolio supporting the pension.

“You do have a bequest motive that isn’t served by lifetime annuities,” AXA head of structured solutions Andrew Barnett said.

“People taking an annuity have no access to capital, and that does become an issue when they have uncertainty about their future expenditure patterns. Lifetime annuities can have a high purchase price or, conversely, the payout is relatively low because of the assumptions the providers make around improving mortality. With a lifetime annuity you generally forgo your control over your assets altogether. It is also no longer unit-linked, so you no longer get the upside when the markets do well.”

According to the OECD working paper on insurance and private pensions, ‘National annuity markets: features and implications’, timing is a risk factor when it comes to purchasing annuities.

The paper stated: “This risk comes in three parts: the movements of investment markets up until the date of purchase, the level of interest rates — and therefore annuity rates — at the moment of purchase, and changes in longevity expectations in the lead-up to purchase, also impacting annuity rates.”

These are among the reasons the market has remained small where there has been no compulsion, and why CommInsure is the only provider of lifetime annuities in Australia.

Levinthal said CommInsure has remained in the market while others have left because there is still a demand from certain segments of the community and the planning network.

“That includes advisers who may have conservative clients or clients looking for guarantees,” he said.

“They still find the features of annuities attractive, and it has obviously done well for them throughout the global financial crisis because their values haven’t fallen as much as clients with more riskier strategies.”

However, he questions whether people should be compelled to take out annuities.

“The nature of annuities is that it is dependent on the economic climate and the level of interest rates; if interest rates are very low, it’s going to be unfair to force people to invest their money in annuities,” he said.

“I think annuities will play an ongoing, small part in the retirement market, but it will always be small. It is a very appropriate strategy to buy an annuity in certain circumstances, but everyone is different and everyone’s needs are different. So advisers will have to consider the whole gambit of options and choose what is best for their particular client.”

Wade Matterson, practice leader of actuarial consultancy firm Milliman, said there is a range of products and strategies that people can opt for to address longevity and market risk apart from lifetime annuities.

“The lifetime annuities market in Australia is underdeveloped as it stands,” he said.

“There’s a range of strategies that people can look at and adopt to provide money in the event that they live longer than they thought they would.

“We’ve built this entire system around giving people the utmost flexibility — choice of provider, choice of fund and asset allocation — and now they say at retirement ‘we’re going to take that flexibility and choice away from you’.

“I feel it’s a difficult psychological barrier to reinvent the system in that way. Whereas a more subtle approach that incentivises people to put their money into an income stream should go a long way to meeting the ultimate goals of the system.”

The future of post-retirement products

Lifetime annuities aside, longevity risk and the need to provide consumers with better alternatives have revived interest in the development of post-retirement products.

Barnett said the global financial crisis has awakened a demand for products where there is a higher level of risk sharing.

“Of all the OECD countries, we have the highest proportion of superannuation money actually in defined contribution schemes,” he said.

“We’ve transferred a considerable amount of market and longevity risk to individuals themselves, and we’ve done that in the last 10 years, which was a very benign market in terms of equity returns.

“Certainly the GFC has led to a sharpening of awareness of the market risk people have to bear themselves. And the capital protected products, and the income guaranteed products, and indeed annuities, can help redress that transfer of risk.”

Various players in the market have been keeping a watchful eye on the US and its product offerings that have successfully found a balance between security and flexibility.

“Australia is more likely to follow the lead of other developed economies like the US, which have what they call ‘variable annuities’,” Levinthal said.

“They are kind of a mix between a lifetime annuity and an allocated pension, where you still invest in whatever you want to invest in but you have longevity protection that protects against market downturn. So it’s a more modern form of product that has the best of all worlds.”

Levinthal said this type of product was not yet available in Australia as there are still some regulatory hurdles to overcome.

“There still needs to be a fair amount of discussion between the industry and regulators to make it happen,” he said.

Matterson agreed that for variable annuities to be developed in Australia, there is a need for regulatory reform.

“We’ve seen in other markets, Europe in particular, where regulators have acted in partnership with the private sector to create an environment where product innovation can occur, and I think that’s beginning to happen in the Australian market,” he said. “But it is something that needs to happen in order to facilitate the market.”

AXA North’s superannuation and personal pension product offerings are similar to what would be considered a variable annuity in the US.

“North is a variable annuity, as they would know it in the United States, but over here it’s a superannuation allocated pension, and it has a guarantee that is formed either to return the original capital or to ratchet up over a period of time and lock in positive market performance,” Barnett said.

As ING is about to release a new post-retirement product, head of product and marketing for wealth management Mark Pankhurst was reluctant to give too much away. But ING has seen the need for building innovative products that manage longevity risk.

“We’re actually spending a fair bit of money and effort on developing a fairly innovative retirement solution, which we are planning on launching later in the year,” Pankhurst said.

Talking about the retirement product market in general, he said there was certainly a lot of interest in building innovative retirement products that manage longevity risk, but a lot of their work has been around capital protection.

In the wealth management business, Pankhurst said ING recently released products built with guarantees. Its Protected Growth Fund locks in a certain proportion of the client’s capital as it rises, and its latest Protected Growth Fund No 2 has no lock-in period limitations and is capital protected.

“If you look at the Protected Growth Funds, they provide a mechanism whereby they dynamically allocate between growth and defensive assets. As the markets start to pick up, they start to allocate more to the growth assets. People pick up the upside, but because they have a protective mechanism as the markets start to drop, they lock in, so you’re actually locking in the gains. People are absolutely looking for that type of style and that kind of protection,” Pankhurst said.

“We’re also looking at some innovations around new retirement products that will provide similar lock-ins and will help to protect the income for customers throughout their life. It’s really been triggered by the fact that people are more cautious as a result of market performance,” he said.

Howes said Challenger is not as focused on product innovation as it is on delivering quality products.

“Our focus is on delivering a high quality, guaranteed income product rather than focusing on complicated product innovation that delivers, in our view, little more than excessive fees and risks to retirees who are in desperate need of reduced risk in retirement and are in desperate need of attractive returns alongside guaranteed income,” he said.

“The more important trend is not so much around product innovation, but rather a realisation that the virtues of simplicity and genuine guarantees of APRA-regulated institutions, like life offices, are very positive relative to more risky, growth and high-yielding stories, which characterised the portfolios of the 90s and early part of this decade.

“It’s more an issue around providing certainty and an attractive return.”

Matterson said that whatever route product providers take, they should keep consumer needs and attitudes in mind.

“Successful products will combine protection against market downturns with a lifetime income, or whatever it might be, to get a broader appeal,” Matterson said.

“A key thing in product design is to recognise that people do have this innate desire to leave something behind. And coming up with products that can provide some sort of income guarantee, but give people the ability and flexibility to do what they ultimately want with their assets, is critical.”