Sun-Herald and Sunday Age: navigating your income options in retirement

Sun-Herald/Sunday Age, November 2009

We’re all living longer. Good news – with a catch. Many of us don’t have enough saved for a long retirement, and as the average life expectancy creeps up, so too does the likelihood of us outliving our savings. This is known as longevity risk.

Traditionally there have been two broad clusters of retirement income products, both of which have their uses, but neither of which are perfect in isolation for retirees.

Annuities – the traditional, lifetime annuities rather than the more recent term annuities – have the advantage that they guarantee you income for the rest of your life, and are usually index-linked to inflation too. But they bring you no exposure to the markets, you can’t pull money out as and when you feel you need it, and if you die earlier than you expected to, the money you used to purchase the annuity is lost.

Allocated pensions, by far the most popular products retirees use, are flexible, give you access to the market, and greater freedom in when you take the money out. But they run out – and if the market doesn’t do what you think it’s going to do, they run out more quickly.

Now, products are starting to appear that bridge that gap: retirement income products that give you market exposure and flexibility, but also a guarantee of income.

The first of this new wave of products came from Axa, under its North brand. The idea of Axa North was to bring capital protection, quite common in investment products generally, to superannuation. It behaves pretty much like any other super fund, with a range of investment options and market exposure, but offers capital protection, at periods from five to 20 years.

The product was launched in 2007 but it’s really the market crash that demonstrated to a shocked market of retirees and pre-retirees that some protection might be desirable. “Over the 15 years up to 2008 we experienced a very strong bull market,” says Andrew Barnett, head of structured solutions at Axa. During that time, he says, Australia developed one of the world’s highest exposure to equities in its pensions, and so the highest market risk; In Australia on average 57% of pension assets are in equities, compared to an average of 36% in other OECD countries. Correspondingly Australia suffered the third worst decline in pension assets of all OECD nations in the financial crisis.

Perhaps as a consequence if this newfound understanding of risk, Barnett says Axa North has garnered around 7% of the entire retail market’s net fund flow since its launch, and now has in excess of A$1.1 billion under administration. And that’s just the start: Axa had been offering a similar product in the US, where it is known as a variable annuity, for 15 years, and over there this style of product manages over US$1.4 trillion, or 14% of the entire US pension market. Since the Australian superannuation industry is worth over A$1 trillion, it’s clear that we could be seeing a lot more of these products if they catch on.

So it was no surprise to see another provider, ING, enter the market in October with ING MoneyForLife Funds. “There’s a real need in the market, fundamentally,” says David Kan, executive director at the retirement and investment solutions group at ING Australia.”We’ve got an ageing population, with a larger number of people spending longer periods of time in retirement. If you look at the products that have been around to service that market, they individually have certain characteristics of what would be ideal. They provide income for life but not access to capital or growth; or they provide access to growth assets but not lifetime income. There’s a need for something that combines both.”

The ING product differs from the Axa one in that it guarantees income for the whole of life rather than a set term. On day one, a protected income base – the amount you invest – is established, and this is used to determine your guaranteed income and the maximum you can withdraw each year without undermining your guarantee. That protected base can’t fall. It can, however, rise: every two years the base is recalculated. If the current account balance is higher than the original base, then the base moves up to that higher amount. As with Axa, a range of investment options are offered varying from a growth to a defensive tilt.

Axa now plans to update its existing North product with a lifetime guarantee (it had previously only provided a market guarantee, which mitigates the risk of outliving your money by ensuring you have more money to draw on, but doesn’t explicitly rule it out). Barnett says this will come out early next year. It’s no surprise that the early movers in this area have been global financial services groups that combine an insurer with an investment arm and have experience in the US markets, but they can expect some homegrown competition too. Macquarie’s Andrew Robertson, head of longevity solutions, says: “It’s certainly our view that this family of products will be quite popular. It meets a bunch of retiree needs in a way that is not met by other products and I think the opportunity to develop variants of that is an interesting opportunity.” Macquarie launched a new business, Macquarie Longevity Solutions, specifically to look at product development here.

So are all our retirement problems solved? Well, even the backers of these products don’t claim they remove the need for other retirement income products – different people have different needs and many will want to opt for a combination of things. And, of course, nothing comes for free. “There is no magic bullet,” says Richard Howes, chief executive, life, at Challenger. “There is no single product that can replace the role of portfolio construction between a financial planner and a client.”

For one thing, there’s the fees. For the Axa product, investors get it through a platform, so typically pay 75 basis points admin fee for that; then there’s a fee for the investment style, which is 45 basis points for the most popular index funds but more for active management; and then a fee for the guarantee, which in the most popular 20-year variant is 90 basis points, adding up to more than 2% and potentially more depending on the investment option. For investors in the ING product, the overall cost will come out around 3%, “and about half of that is the cost of the guarantee,” says Kan. “That’s what you’re paying for peace of mind.”

For many people, that’s a fair price to pay for that peace of mind, but it’s not the only answer. Howes at Challenger thinks the high fees on products like these and on allocated pensions generally can outweigh the advantages those products confer. He cites a Rice Warner survey last year that put the average retail allocated pension charge at 1.9% once platform, admin, advice and management costs were considered. “For an allocated pension fund with a balanced investment option, 2% is about all you could reasonably expect as a return over the government bond rate for taking on these assets,” says Howes. “So any benefit from investing in growth assets in an allocated pension is eroded by the charges. And the problem with these silver bullet new products is that on top of those fees you have insurance fees for longevity risk and put option fees for market downside.”

Challenger’s view is that investors should consider the boring, simple stuff: annuities. “We think the annuity is the logical choice for the defensive part of a retiree’s portfolio,” he says. “It pays a return significantly higher than that which could be traditionally expected from assets like bond funds, and does it without fees and without risk.”

Challenger recently launched the Guaranteed Income Fund as a way to make annuities available on platforms, which is where the vast majority of investors and planners do their investing. These come in a range of durations – at the time of writing they varied from paying 6.24% to 7.28% a year, with terms running from 2011 to 2017.

These are not the same as lifetime annuities, which still don’t appear on platforms but are instead bought directly; they’re not indexed to inflation, though Howes says “we envisage future iterations of the product that will include indexed annuities”.

Lifetime annuities certainly have their place too, although Australians have not embraced them as other markets have. “They offer the very attractive feature of taking away longevity risk in the sense that they will provide a guaranteed income for as long as the retiree lives,” says Nick Callil, principal and consulting actuary at Watson Wyatt. “But this downside that if you die early your money remains at the life office – that’s been a real disincentive. People tend to have a bit of a blind spot: they say, what if I die tomorrow and all my money’s gone? They don’t ask the opposite question, which is: if I don’t die and I live until I’m 100 will I run out of money?”

This attitude has partly contributed to the relative popularity of allocated pensions. “Allocated pensions give people this feeling of comfort that the money, if they die, is still there for their dependents,” says Callil. “And they are simple: people think of them as a bank account. The problem is they don’t offer any protection against people living longer than they might expect, and hence not having enough money to last their lifetime.”

Before deciding which products to go with, retirees need to be clear on what they’ve got and how they want to use it. “The first step you’d normally be looking for retirees to start thinking about is: how much have I got saved in all my sources?” says Callil. “Also, what’s my health like? Am I looking to generate income for a long or short time? What are my spending aspirations? And will I be eligible for the age pension?”

Robertson believes Australia is going to experience a whole new wave of retirement products, and says Australia has lagged the rest of the world in this regard for some time: he blames this on a focus on the strong equity market, low awareness of longevity risks, commercial realities stopping super providers to take risks of new products, and regulatory issues.”The reason it’s exciting at the moment is you’re seeing a real opening up on all those barriers. The baby boomer wave is approaching retirement, there’s a lot of money flowing into the market, the financial crisis has increased everyone’s risk awareness, and the Henry and Cooper reviews [government studies of tax and investment] are identifying these things as important issues.” He expects capital guarantees in superannuation to be the first wave of a new period of innovation.

It’s worth remembering, though, that capital protection gained something of a bad name during the financial crisis. That’s because some products were guaranteed by groups such as Lehman Brothers which didn’t survive long enough to honour them. Axa and ING are highly-rated European insurers; other groups launching products will have to convince people of the quality of their backer.

Retirement income has been moving along for years anyway: you might recall the arrival of so-called TAPs, or term allocated pensions, launched a few years ago to comply with beneficial tax rules, which then became obsolete when the rules changed. But one useful development is that, since a series of changes in 2007, the tax treatment of these products is identical. “It’s a completely level playing field now,” says Barnett.

CASE STUDY

In 2004 Arthur and Mary made an apparently wise, and certainly commonplace, allocation of their $425,000 retirement savings. Arthur put $200,000 into an annuity, and $100,000 into an allocated pension; Mary, $125,000 into an allocated pension.

The annuity investment was designed to maximize their Centrelink benefits. The annuity they chose, with their advisor Frank Gayton at Industry Fund Financial Planning in Melbourne, paid a locked-in rate of 6.8% for 15 years with 3% indexation; those funds will be exhausted at the end of those 15 years. Like all annuities, there is no flexibility to withdraw any lump sums along the way. To counteract this defensive instrument, the allocated pensions were invested aggressively.

Five years on, that annuity – intended to be the defensive bedrock of the portfolio – has instead been by far its star performer. The amount in the annuity today is down 33%, but that’s because it’s been paying out income and is one third of the way through it. The allocated pensions are down enormously: 45% in Arthur’s case, 52% in Mary’s. Overall, their retirement funds are already down 41%, to $249,000.

There are two ways of looking at Arthur and Mary’s experience. One is disappointment: “We wish we had put all of our money into an annuity,” they say today. Their story is a clear example of how thousands of retirees have suffered because of a wholly unexpected collapse in stock markets. Naturally, some of that value will recover, and Australian markets have already improved considerably from their lows, but a market crash when very early into retirement has a highly damaging effect on how long overall retirement sums will last. That’s partly because unlike other people who can ride out the lows by leaving money invested, retirees have to keep withdrawing to live, even when investments have fallen to absurdly low levels.

The other way of looking at it is to be grateful that they split the sums between annuity and allocated pension in the first place. Had they put the lot in allocated pensions, the situation would look much darker. Adviser Gayton recommends all members consider an annuity as at least a part of their post-retirement investment.

Names have been changed