In 2014, the Financial System Inquiry (FSI) concluded that account-based pensions (ABPs), used in isolation, cannot efficiently convert superannuation assets into retirement income. Modelling by the Australian Government Actuary (AGA) showed that retirement income can be 15 to 30 per cent higher by combining retirement products, particularly by allocating some money to a lifetime income product.

The main problem with allocating 100 per cent of your superannuation to an ABP in retirement is you don’t know how long you are going to live. This means you don’t know how much income you can safely draw from your ABP each year. A growing body of research indicates that Australian retirees have a “fear to consume”, as the majority of them only draw out the required minimums each year, which means a relatively large balance is left unused on death.  

Retirees’ concerns over how long they could live are valid. While the average age of death for retirees over 65 in 2016 was 83, at least 2,000 deaths occurred in every age group from 66 to 96, demonstrating that retirees simply can’t tell how long their retirement time frame is.

Other research indicates that age of parents’ death may not be a good indicator of the age of the retiree’s death, as causes of death may differ.

Over 2,000 years ago, the Romans solved this problem by using the annuity — probably the oldest financial product in the world. Annuities remove the risk of “money running out” and mean you can be confident to spend your entire income. US studies show that retirees on lifetime incomes (e.g. annuities) exhibit higher levels of satisfaction in retirement, even taking the wealth effects into account. A University of Michigan study of over 20,000 retirees from 1998 to 2010 showed that those retiring in each year who had annuitised 30 per cent or more of their retirement savings had at least 20 per cent higher levels of retirement satisfaction than those who did not annuitise any of their savings.

Many financial professionals, however, baulk at the current cost of traditional annuities. In today’s low-interest rate environment, annuities are often perceived as poor value for money. But part of the pricing of a traditional annuity is not just insuring longevity risk but also providing investment guarantees — often for 30 or more years into the future — and these are very expensive to provide.

But what if lifetime annuities didn’t need to include investment guarantees? What if retirees with a balanced attitude to risk could still benefit from longevity protection but maintain some exposure to growth assets — as they do with an account-based pension. For these retirees, the ideal retirement product could be an investment-linked annuity (or real lifetime pension), i.e. an ABP with longevity protection that doesn’t decline in real terms over time.

With an investment-linked annuity, each year’s income varies based on the performance of a selected investment option, rather than as a specific dollar amount of income.

Note: The following examples are highly simplified to demonstrate some basic concepts. They should not be relied on when making decisions about a specific financial product.

Example 1

In this example, the initial level of payment specified by the investment-linked annuity gets set based on the retiree’s life expectancy at the time the annuity was purchased.

Consider a 66-year-old male, George, who has $500,000 of superannuation account balance. The expected number of years of annuity payments payable to him over his lifetime, allowing for longevity improvements using the ALT2015-17 life tables, is 21.2 years. Therefore, his initial annuity income might be set to be $500,000 / 21.2 = $23,585 per annum.

The investment-linked annuity provider guarantees the longevity risk (i.e. to ensure his payments continue for life — even if he lives to the end of the life tables) but not the investment risk (the price of those units will vary in line with underlying investment performance).

George’s income will move up and down over time based on the investment fund unit price at the time of each payment. If over year 1 the unit price increased by 6 per cent net of fees, then George’s retirement income will then be 6 per cent higher, being $25,000 at the start of year 2.

Note that at inception, George’s income of $23,585 was slightly less than the minimum from an ABP (which is 5% x $500,000 = $25,000). However the expected increases in his investment-linked annuity income over time equals the expected return of his investment fund (net of fees). For a balanced fund, George assumes 6 per cent per annum.  If his unit price goes up 6 per cent per annum for 10 years, then his income would rise to $42,237 per annum.

Example 2

George has an expectation that his investments will earn 6 per cent per annum, but his actual target for his living standard is to keep pace with inflation. 

He wonders if it’s possible to modify the annuity so that his income increases more in line with CPI than with full market returns.

George asks the provider: “Would you be willing to increase my income if I agree to forgo 3 per cent per annum of all future returns?”

The investment-linked annuity can be modified to smooth out the expected increases over the course of retirement. This is done by bringing forward some of the expected future investment returns and using this to allow a higher initial income when the annuity first commences.

A higher initial income can be paid to George. But instead of increasing in line with investment fund returns, his income will increase by the investment returns less 3 per cent. 

The annuity provider converts his initial $500,000 into an income per annum. But instead of using his straight life expectancy for this calculation, they adjust the factor to 15.2. (which is actuarially equivalent to Example 1 but incorporating the 3 per cent per annum adjustment).

This gives a year 1 income of $500,000 / 15.20 = $32,895 per annum.  

By agreeing for his retirement income to increase by net returns less 3 per cent per annum, George’s income commences $9,310 higher than in Example 1.

If George’s investment fund does earn 6 per cent per annum net of fees, then his retirement income will increase by 3 per cent per annum (= 6% - the 3%), which is more in line with potential inflation, i.e. he can maintain his target lifestyle. 

Decision factors

• An investment-linked annuity can provide George with confidence to spend in retirement — he cannot outlive his income.
• However, the income level changes over time based on the returns of the investment fund.
• Most annuities offer a guarantee period — meaning a minimum of, say, 15 years of income is payable in the event of early death.
• By agreeing to modify the annuity, George can achieve a higher income at inception which then increases more in line with a CPI target (as opposed to a lower income that increases with full net returns).
• Choosing an investment-linked annuity with a suitable exposure to growth assets can help to deliver an efficient lifetime income and offset the effects of future inflation.
• It’s possible for an investment-linked annuity to offer investment choice through a switching process.

This article is an introduction only. Investment-linked annuities, and equivalent lifetime pensions, are likely to be part of the superannuation landscape as the government’s proposed Retirement Income Covenant moves forward. They provide an alternative to traditional annuities, which appear to many investors as having poor value, and account-based pensions, which carry longevity risk. 

New Centrelink means-test incentives were put in place for lifetime income streams from 1 July 2019. This can provide an instant uplift in age pension income for retirees subject to means testing.

Investment-linked pensions or annuities could be attractive to older or bereaved members of an SMSF who no longer want to invest their own superannuation assets and are happy for professional investment managers to do that on their behalf — thus, giving them less responsibility regarding investment, more time to enjoy their retirement, with much less stress, e.g. about running out of money — which is what retirement could be all about.

Jim Hennington, chief executive, Apricot Actuaries; Peter Rowe, general manager, Optimum Pensions; David Orford, managing director, Optimum Pensions