By Partner Geoff Sanders, Senior Regulatory Counsel Michael Mathieson and Senior Associate Simun Soljo
A key risk faced by self-funded retirees is the possibility that their superannuation savings will not last as long as they will. While lifetime pensions and annuities issued by life companies can assist in addressing this risk, there has traditionally been a relatively low uptake of these products by retirees in Australia.
This has attracted attention in the current Financial System Inquiry. The chair of the Inquiry, David Murray, said in a recent speech that:
Our superannuation settings focus on maximising wealth creation during the accumulation phase, rather than the delivery of income at the time of retirement. There is a paucity of attractive financial products that help retirees manage their income and risks, particularly longevity risk. (Speech, 1 May 2014)
The reasons for this have been the subject of considerable policy debate already, but the Inquiry presents another opportunity to bring them to the fore. The Inquiry may recommend changes to the regulatory settings to make longevity products more attractive. It may also (or instead) recommend that retirees be compelled to take up longevity products in some way.
Irrespective of whether the Inquiry recommends a move to compulsory uptake of lifetime pensions or not, the recent UK move away from compulsion may offer some lessons and a useful comparison, and is the focus of this article. A subsequent article will consider some of the key regulatory settings that inhibit product innovation in this area and discourage the uptake of lifetime annuities by retirees.
The current regulatory and tax settings in the UK effectively require retirees with a defined contribution (or accumulation) pension account to use at least 75 per cent of the account balance to purchase a lifetime annuity. Failure to do so results in the retiree facing a punitive tax rate of 55 per cent (whereas annuity payments are taxed at the retiree's marginal tax rate when paid). The remaining 25 per cent of the retiree's account balance may be taken as a tax-free lump sum.
However, the UK Government recently announced changes that would allow retirees to take their entire account balance as a lump sum. Under the proposed changes, the first 25 per cent of a lump sum would continue to be tax free, but the balance will be taxed at the retiree's marginal rate (rather than at 55 per cent). The changes are intended to commence from April 2015. The Government is currently consulting on the implementation detail and many questions remain unanswered.
The move was described by the UK Government as the biggest change to pensions since 1921 and is based on the notion that '[p]eople who have worked hard and saved hard all their lives, and done the right thing, should be trusted with their own finances' (Chancellor George Osborne). However, in an echo of the debate in Australia, critics of the move have pointed out the move away from compulsory annuities significantly increases the risk that retirees will run out of savings and will have to fall back on government-provided pensions.
While the UK changes came as somewhat of a surprise, they have been welcomed by many retirees, who have been unhappy with various aspects of the annuities on offer.
The key issues appear to be product complexity and a perceived lack of value for money.
Retirees commencing an annuity are required to nominate at commencement whether they want income payments to be indexed or remain the same, as well as to decide about reversions and survivorship. These are difficult decisions to make immediately upon retirement and have the potential to affect the pensioner (and their dependants) for decades.
Further, while it may be difficult for ordinary retirees to determine whether the return offered by annuities actually represents good value for money, the perception has been that they do not. This may be the result of a number of factors, including:
- Increasing life expectancy of retirees – a product providing a guaranteed income stream for life would naturally offer a lower rate of return for the same capital investment as life expectancies increase.
- Increasing capital adequacy requirements for insurers that issue annuity products, which directly reduces returns to investors.
- Low rates of return on life company investments, which have fed into lower annuity rates.
- A view (whether founded or otherwise) that insurers have sought to maximise their own profits ahead of the returns offered to investors.
The announced changes have been a major blow to life insurers offering annuities in the UK, with sharp falls in the value of their shares. Some estimate that sales of annuities could fall by as much as 75 per cent once the changes are implemented. The changes may also see annuity rates drop even further as insurers may feel the need to adjust annuity rates down on the assumption that only those who expect to live the longest will seek to purchase these products in an environment free from compulsion (this is referred to as adverse selection risk). The further reduction in annuity rates could cause further declines in demand, and so a downward spiral.
There are some valuable lessons for the Australian superannuation and retirement sectors coming out of the UK experience, particularly given that the predictions of a massive reduction in annuity uptake in the UK following the removal of compulsion suggests that increasing uptake of annuity products without compulsion will be difficult.
In particular, there is clearly a policy decision for our Federal Government to make between the competing objectives of giving retirees the freedom to access their superannuation savings as and when they wish, and requiring self-funded retirees to manage longevity risk to reduce the likelihood of having to rely on government-provided benefits. We await the results of the Financial System Inquiry in this area with interest to see if the Inquiry makes any recommendations as to how best to balance those competing objectives. Areas of focus in this respect may include the following.
- There is currently no compulsion in Australia for retirees to purchase lifetime annuities and they have not proved popular, despite the fact that various types of products are available. While the regulatory and tax settings could be adjusted to make these products more attractive to retirees (we will discuss these in a future article), this may not be enough to significantly change consumer behaviour if the rates of income offered by these products are perceived to be poor value for money. As such, one easy way to address longevity risk would be for the Government to simply compel retirees to take up some or all of their superannuation savings in the form of a lifetime pension or annuity. This would have obvious appeal in some parts of the industry, as it would significantly grow the assets held in statutory funds by life companies backing these annuities, which may, in turn, be more likely to look for very long-term investments such as in infrastructure. However, any move to introduce compulsion would likely be unpopular, especially with those approaching retirement, given the issues highlighted in this article and the experience in the UK. Compulsion also raises issues of fairness in that it would be detrimental to groups that have higher mortality rates (as identified in the Henry Review) and could be difficult to implement in the current political climate.
- If non-compulsion levers are used instead, issuers will continue to need to be able to demonstrate the value proposition of annuity products. As can be seen from the UK experience, consumers may view annuities as inherently risky because of the uncertainty about life expectancy – if they die early, they will 'lose out' (although some providers have addressed this by offering a guarantee of return of capital within a specified period). The role of product manufacturers in designing products that are simple to understand and yet meet the needs of retirees will be significant in this respect, along with better investor and adviser education about the factors affecting annuity values.
- Finally, another issue worth investigation may be an examination of the regulatory framework, and, in particular, the regulatory and capital adequacy requirements imposed on insurance companies, to determine if they are excessively restrictive, especially in comparison to similarly regulated entities, such as banks.