Funding your retirement: the role of life annuities

As workers enter retirement they face the new problem of funding ongoing consumption from their personal savings and public pension entitlements. How to manage retirement spending is a problem for a growing number of individuals and for society as a whole.

Around three million people in Australia are now aged over 65 years, rising to around eight million by the middle of the century, resulting in a doubling of the age dependency ratio from 20 per cent to 40 per cent. Even allowing for an increase in the eligibility age to 67, Treasury estimate that spending on the Age Pension will rise by about one percentage point of gross domestic product (GDP), an increase of around one third.

The latest CEDA research report, The super challenge of retirement income policy discusses two groups of retirees – those who spend their personal savings too quickly and draw heavily on the public pension, and those who are overly cautious. Both these groups create and incur welfare losses.

A retiree who knew his or her remaining lifetime, returns on invested savings and public pension entitlements could exactly match their financial resources to their consumption plans each year. But in reality, plans are made and executed in a haze of uncertainty.

The risky, long-horizon, planning problem that confronts retirees is daunting, especially given the modest financial skills of most.

The economist's favourite remedy for managing decumulation is a life annuity, a main feature of which is the predetermined payouts that retirees receive periodically during their lifetime. Life annuities insure longevity risk, pay regular guaranteed income, and if they are fairly priced, add a mortality credit to the return on the underlying asset.

However, purchasing an annuity entails forfeiting capital to the provider. Many people find this unappealing, especially those who want to leave a bequest, who think they might need liquidity for emergencies or who want to make sure they can benefit from risky asset returns. In addition, people who receive pension streams from other sources are less likely to want annuities.

Very few Australian retirees take up the annuity remedy (even partially), and their lack of interest is typical of voluntary annuity markets around the world. Although in recent years slightly more Australian retirees have withdrawn their superannuation through income streams, including around 2,000 new life annuity policies sold in 2013-14, still around half of superannuation assets is withdrawn as lump sums, and most of the rest is transferred to phased withdrawal products that have no longevity protection and no upper limit on spending.

Public policy has protected freedom of choice of retirement benefits and although some tax and social security settings favour gradual decumulation over lump sum withdrawals, the income and assets testing of the Age Pension payment creates an incentive to spend wealth faster and hold riskier assets than otherwise. This raises the question of whether the best interest of retiring workers is served by making some annuity purchase compulsory. It also raises the related question of whether a default strategy could or should be introduced to guide decumulation.

One way to answer these questions is to use the tools of simulation and optimisation to design the best combination of annuity and liquid investment account for people of different genders, wealth and risk tolerance in a range of different financial scenarios. Doing this computation shows how much influence the Age Pension has on ideal decisions.

First, simulations show that making annuitisation mandatory would be detrimental for low wealth retirees and would not improve the welfare of richer retirees much. The Age Pension is an indexed life annuity with payments that are negatively correlated with wealth because of the means tests. It crowds out a large proportion of voluntary annuity purchases. Unless their essential spending exceeds the maximum Age Pension, low wealth retirees are generally better off holding liquid investment wealth.

Simulations also show that modest amounts of annuitisation do make medium to high wealth households better off, but the best level of annuitisation will vary with financial conditions and risk tolerance. This variation between people makes it hard to set a compulsory or default rule.

Deferred annuities are predicted to be more attractive to poorer retirees, because the premiums are lower than immediate annuities. However deferral is very unappealing for wealthier retirees because the delayed payment stream starts around the time that natural decumulation of capital, in conjunction with the means tests, makes individuals eligible for a higher Age Pension payments.

Sources: Ishkahov, Fedor, Susan Thorp and Hazel Bateman (2015) ‘Optimal annuity purchases for  Australian retirees’, Economic Record, 91(293), 139-154.

Professor Susan Thorp is a member of the CEDA Advisory Group for CEDA's research, The super challenge of retirement income policy launched in September.