GUIDANCE PAPER THE ROLE OF ANNUITIES IN RETIREMENT INCOME PLANNING

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1 GUIDANCE PAPER THE ROLE OF ANNUITIES IN RETIREMENT INCOME PLANNING Annuities can be an important part of an adviser s toolkit for retirement income planning. This paper builds on the retirement resources we have recently provided and considers how annuities can be included in a client s portfolio and their relationship to the traditional approach of account based pensions. The paper is focussed on long-term retirement planning and discusses lifetime annuities and long-term annuities (over five years in duration). Colonial First State will continue to bring advisers the latest retirement ideas as advice strategies and product solutions continue to evolve. Introduction The Melbourne Mercer Global Pension Index, published in October 2015, reconfirmed that the Australian superannuation system is one of the world leaders for assuring that people are saving for their retirement. Despite this, the survey noted that sustainability in the pension phase is an issue. In recent years, the wealth management industry has recognised how retirement income planning can dramatically differ from pre retirement wealth accumulation. Apart from the well-publicised demographic shift (with baby boomers commencing retirement) and increased life expectancy of the Australian population, there are a number of key factors that have resulted in advisers developing and adopting new post-retirement frameworks. Some of these are: increasing financial literacy and interest in superannuation uncertain economic and investment market conditions during and since the Global Financial Crisis (GFC) continued investment market volatility for both equities and fixed interest investments the general consensus that the Age Pension alone is not providing a satisfactory level of income for most retirees the increasing recognition that the pension system safety net cannot be sustained at current levels in the future. Core to the development of new retirement investment strategies is advisers acquiring a much deeper understanding of their clients needs and goals in retirement. Retiree needs are essentially as follows: Income certainty of income and the ability for that income to meet basic/essential lifestyle needs Capital access to capital as needed, generally in a lump sum form. To achieve this, retirees need to manage the following major risks: Longevity risk the risk of outliving their savings Market risk the risk of being exposed to movements in the market over time Sequencing risk the risk of significant negative returns early in retirement Inflation risk the risk that price increases erode the purchasing power of their retirement savings. While the issues outlined above are not new, there have been advances in behavioural finance that may result in advisers capturing different goals for the management of their clients investment portfolios before and after retirement. Wade Pfau and Jeremy Cooper 1 have advocated a new approach to retirement planning, describing the opposing retirement income philosophies as being probability-based and safety first. 1 Wade Pfau and Jeremy Cooper, The Yin and Yang of retirement income Philosophies, Adviser use only

2 The two schools of thought Probability-based strategies apply traditional wealth accumulation techniques to the account-based pension (ABP). The investment portfolio, specified by its strategic asset allocation, seeks to generate the highest possible returns to meet a client s overall needs, with the highest probability of success. Probability-based approaches suit an investor that is, for example, comfortable with an outcome that has a 90% chance of success. In practice, advisers wrap behaviour based and/or investmentbased strategies around the portfolio to help clients deal with market volatility and resist the temptation to make poor choices at bad times. Approaches frequently used include: Allocating capital into three sub-portfolios or buckets, where a cash portfolio covers spending needs for the initial three years, a capital stable (or bond) portfolio covers the subsequent two years and a balanced portfolio for the remaining capital. Using investment products that increase exposure to diversifying asset classes that reduce the reliance on equity markets and more dynamic management of asset allocations. Including new asset classes/products in the portfolio that are managed differently to traditional long-only funds. These include low volatility funds, long/short and market neutral hedge funds, tax aware funds and various tail risk hedges. Advocates of these believe that they can assist the portfolio to meet its objectives while protecting on the downside. Loading the ABP with income-focussed products. These approaches are based upon historical data to generate an efficient frontier or simulations of future economic cycles to produce an optimal portfolio, and are unlikely to protect clients from a protracted decline in markets. This is due to the combined effect of capital being depleted when the client can no longer contribute to their superannuation. It has also been shown that so called safe withdrawal rates may not provide long-term income, especially when a significant negative market event occurs shortly before or after retirement or in long periods of volatile markets which arguably is the prevailing investment environment. In addition, studies have shown that even when markets are benign, retirees with ABPs adhering to minimum drawdown rates (as specified by the SIS regulations) can have an unnecessarily low standard of living, especially during the early active years of retirement, and leaving a sizeable bequest. Safety-first advocates would be uncomfortable with an outcome that has a 90% chance of success, focussing instead on the 10% chance of failure. This, in turn, implies that the client has a good understanding of the goals and priorities they have in retirement. A typical hierarchy of objectives would be: 1 basic needs 2 contingency fund (for emergencies) 3 discretionary expenses 4 legacy goals. Safety-first investors are not trying to maximise their returns on a risk-adjusted basis or beat an investment performance benchmark. In the purest sense, they are asset liability matching, ie their goal is to have cash flows available to meet spending needs as required. Income certainty is one of the key benefits of annuities. Safety-first advocates would ensure that the client s basic needs are secured with annuities (considering also the availability of the Age Pension and other social security benefits) with the balance of capital allocated to an ABP, and managed in the traditional probability-based manner to achieve the higher goals. The recent Financial Systems Inquiry into Australia s retirement income system noted that over-reliance on individual APBs and a lack of risk pooling (which is done by annuities) could result in retirees outliving their savings, because they don t have an effective way to manage their exposure to longevity, inflation and investment risks. 2 Annuities refresher In their simplest form, annuities provide a guaranteed income for the client for an agreed term or for their lifetime. They provide advisers with an important planning tool with key advantages being: guaranteed regular income payments unaffected by movements in investment markets and changing economic conditions the rate of return is guaranteed for the term of the annuity no ongoing management or account keeping fees (although elements of these are captured in the rates) CPI linked versions can provide inflation protection removal of longevity risk using lifetime annuities the ability to tailor various return of capital options for fixed term annuities social security maximisation taxation benefits. However, annuities also have limitations that need to be considered, including: The lack of liquidity (significant exit penalties can apply for early withdrawal); Locking funds in for a long term or lifetime at current interest rate levels (partially mitigated by the mortality pooling for lifetime annuities), and Lack of transparency with respect to underlying assets and issuer risk. For a more detailed analysis of annuities and the taxation and social security implications, refer to the FirstTech Annuity Guide. 2 Financial Systems Inquiry, Final Report, 2014, page 90.

3 Characteristics of annuities from a retirement income perspective Numerous academic studies (based on volatility and correlations as measures of risk) indicate that the allocation to annuities is simply funded from the defensive portion of the client s assets. This is also logical when it is recognised that the insurance company providing the annuity is investing those funds primarily in a fixed income portfolio. From the above, it follows that shorter dated annuities and term/lifetime annuities with a 100% residual capital value (RCV) could be classified as fixed interest. Annuities tend to outperform bond funds as a retirement income tool because they offer a higher return by actuarially pooling risk across a large range of participants (risk pooling and mortality credits), rather than through seeking investment returns. Unlike annuities, bond funds are still volatile and subject to sequencing risk. If the client cannot met their spending needs, a bond fund may be sold at a loss if interest rates rise (which is likely to be the case going forward), As Australia does not have a long-dated bond market, the client will still need to re-invest the maturing bonds on maturity and incur reinvestment/interest rate risk. Interest rate risk is eliminated with annuities because spending amounts have been securely funded. What are some of the ways to implement annuities in retirement portfolios? Retiree portfolio considerations As there are many ways to conceptually incorporate annuities into a client s retirement income portfolio, Colonial First State recently commissioned Ernst & Young to build a stochastic model to determine what product combination delivered better outcomes for retirees. The conclusion reached was that hybrid options, where a lifetime annuity is combined with an ABP, often delivered superior outcomes for clients. This was especially the case when the clients lived to or beyond their life expectancy. For more detail on these findings, refer to our paper The Retirement Income Puzzle Why annuities may be Australia s missing piece. Determining if annuities are appropriate for the client and what amount should be allocated to annuities, involves having an additional discussion with the client alongside the traditional risk profiling discussion. This would try to further understand the client s objectives as follows: The importance of maximising the Age Pension: While this is clearly a function of the client s financial position and spending intentions, the fact remains that 70% of retirees receive the Age Pension with 60% of those receiving the maximum rate. 3 Regulations have changed in that APBs purchased on or after 1 January 2015 are now subject to deeming rules (ie assessed the same way as other financial assets by Centrelink). It is also worth noting that the asset test advantages of lifetime annuities will significantly improve from 1 January This makes annuities one of the very few ways to maximise the Age Pension. How concerned is the client that their retirement funds may not last? This is a discussion about the merits of a probabilitybased approach (at one extreme being 100% APB) against a safety first approach (with 100% allocated to a CPI linked lifetime annuity at the other extreme). Also takes into account factors such as the life expectancy of the client in terms of their own health and health/longevity of relatives. Is the client prepared to give up some upside from investment performance in exchange for the security of a guaranteed income stream? This point is discussed later in this paper. Does the client require certainty of income for a set period or for life? What are the client s liquidity requirements, especially in the earlier active years of retirement? How important are the client s estate planning considerations? From the above, it is likely that each client will require a degree of customisation, although it should be possible to create simplified rules as to the amount of annuities required for certain client cohorts. Based on the above, there are two main methods to incorporate annuities into a client portfolio. 3 Superannuation in the post retirement phase: the search for a comprehensive income product for retirement, Australian Centre for Financial Studies, 2015.

4 1 Fixed allocation (average retiree) In this approach, the annuity sits alongside other portfolio assets in a retirement portfolio. The annuity allocation is thereby treated as a standard portfolio asset, albeit one that offers unique risk/return and Centrelink benefits. As noted above, this allocation is simply funded from the defensive portion of the client s assets. Optimisation strategies suggest that an allocation of 20 30% may improve the longevity of the portfolio beyond the client s life expectancy. The fixed allocation approach is most suited to a traditional probability advice framework and where the client does not have a strong preference to prioritise cash flow needs, however finds comfort in having a higher level of guaranteed income over the Age Pension. The annuity provides a level of predictable income and capital preservation that is not provided by traditional portfolio assets such as income equities and fixed income. For long term and lifetime annuities, the strategic asset allocation (SAA) framework can be illustrated as follows: Traditional Asset Allocation Approach Growth Defensive Growth Defensive Annuity 2 Income layering (objective-based) This approach represents a hybrid of traditional portfolio construction and the implementation of the safety first approach. Here we explore the appropriateness of annuities and their ability to improve the probability of meeting client objectives. This strategy uses a combination of the Age Pension, an ABP and annuities to provide a guaranteed level of income. By adding a lifetime annuity to the client s portfolio, the gap between the Age Pension, ABP and the clients desired basic level of income can be filled. For example, the lifetime annuity (in combination with the Age Pension) can cover necessary costs such as food, clothing, utilities, insurances and health expenses (basic needs) without being exposed to market risk. After securing this base income level, further annuitisation can be explored to assist with covering the desired income. For example, in early retirement when clients generally require a higher level of discretionary spend, term annuities can be used to provide additional income for specified periods. This approach naturally leads to a discussion on the trade-offs between a 100% probability-based approach vs a 100% safetyfirst approach. The diagram below illustrates the income layering concept. Income needs Minimum income level Annuity Age Pension Desired income Age Pension + Annuity meets minimum income. This diagram shows the interaction between the guaranteed basic income needs and the ABP over a retiree s life stages. $ Basic income needs Comfortable living Peak spending years Account based pension Lifetime annuity Age Pension Active phase Passive phase Aged care Time Once the amount and type of annuity is agreed upon, the next stage is portfolio construction. A strong argument exists to exclude lifetime annuities from the asset allocation process. This recognises that the primary purpose of the annuity is to capture an income stream rather than the underlying asset. Supporting this treatment is that the client has no expectation of liquidating a lifetime annuity whereas bond funds are marked to-market. Excluding annuities from the asset allocation process has the benefits of allowing the remaining assets to be invested in accordance with the client s risk profile. Effectively we have created two portfolios (annuity and ABP) that are more closely aligned to the client s needs. The following illustration contrasts income layering with fitting an annuity in a traditional SAA: Objective 1 Annuity Age Pension Objective 2 Growth Defensive RP

5 Options for investing the account based pension 1 In accordance with the client s risk profile From an asset allocation perspective, term annuities and lifetime annuities are part of the defensive component of the client s assets. Accordingly, the balance of the client s assets, being the market-linked portfolio, can be invested in accordance with the client s risk profile. This is the same principal as the fixed allocation approach above, but has the following advantages: The client s defined essential cash flow needs have been guaranteed by the Age Pension and the annuity. The adviser has the opportunity to maximise the Age Pension. There has been a rich discussion between the adviser and the client on the client s objectives. The market-linked portfolio fits into the client s understanding of risk tolerance. 2 In a more aggressive risk profile The approach above does result in the market-linked ABP portfolio meeting traditional risk profiling based risk/return objectives, however, the certainty that an annuity provides in terms of minimum income levels provides an opportunity for the client to invest more of the market linked portfolio into growth assets. This increases the likelihood of the client having more discretionary income or meeting higher goals. Put another way, when the two portfolios (annuity and market linked) are combined, the overall portfolio is arguably more conservative than the risk profile suggests. This does necessitate a deep discussion with the client on the difference between their risk tolerance and their capacity to take risk. This is especially the case where the client still has concerns over longevity risk but is uncomfortable with increasing their allocation to annuities. To illustrate, if we take an example where the client s risk profiling preference results in the remaining investable funds being invested in a conservative income portfolio we might get the following result: 25% Annuity 75% Retirement income model Annuity + Age Pension meets desired income floor. Market-linked portfolio meets client risk tollerance expectations Combined portfolio meets epectations for desired income/capital longevity. If we move to a more objectives-based framework and recognise that the client may have more capacity to take risk, as basic income needs are assured, then the increased exposure to growth investments might look like this: 25% Annuity 75% Retirement growth model Annuity + Age Pension meets desired income floor. Market-linked portfolio meets client risk tollerance expectations Combined portfolio meets epectations for desired income/capital longevity. Here, the adviser is having two conversations with the client, each with a different focus. Firstly a non-investment conversation about the client s basic income needs in retirement and secondly an investment conversation about having a portfolio that will generate certain growth to meet higher goals. The result for the client is as follows: a desired income floor supported by a lifetime annuity product a portfolio within their ABP with sufficient growth exposure to meet desired spending objectives a clear distinction between these two objectives and the two portfolios that support them a clear process leading to why the more aggressive option has been selected realistic expectations as to how the ABP portion of the portfolio is likely to behave. An interesting outcome of this approach is that in traditional portfolio construction there is a trade-off where locking in spending or reducing portfolio volatility generally means sacrificing growth on the upside. In this case, with the combination of the annuity and a more aggressive risk profile, there is a good probability that the client will recapture the upside as well as being protected for basic needs on the downside. Additionally, the adviser has the opportunity to use product selection in the growth portfolio to lower exposure to market risk. The actual trade-off being made is in respect of liquid financial assets remaining over time. In early retirement, liquid financial assets will naturally be less with partial annuitisation. The value of liquid financial assets falls 25% when 25% of assets are annuitised. However as demonstrated by Wade Pfau 4 with the balance of a portfolio invested in a market related portfolio, the financial assets grow and may catch up again in later years. It is likely that such a trade-off is quite acceptable to a client, especially compared to a situation where market risk/ sequencing risks are of great concern. As with any traditional investing approach, we can see the trade-off that the conservative portfolio, while meeting risk tolerance and minimum income considerations, may have a low probability of meeting desired income/capital wants in the longer term. In other than a basic income needs sense, the portfolio does not meet the client s long-term objectives. 4 Wade Pfau, Why bond funds don t belong in retirement portfolios, 2015.

6 What is the optimal allocation to annuities? As is the case for all asset classes, there are many different opinions and approaches to answering this question. Rather than being prescriptive, the following ideas are often considered: Asset allocation limitation As annuities are defensive in nature they are funded from the defensive part of the portfolio. Hence the asset allocation guidelines create a ceiling, eg 40% in a 60%/40% growth defensive risk profile. (Although in practice retirement portfolios are likely to hold a cash allocation which would not be annuitised). ASFA retirement standards Another consideration is some of the optimisation modelling work done. To determine the ideal level of income we could use the ASFA retirement standards which benchmark the annual budget needed by an Australian retiree to fund a comfortable or modest lifestyle. The current numbers for a comfortable lifestyle are around $42,000 for a single person or $58,000 for a couple. Working within these parameters we can look to determine the ideal account balance for annuity allocations. While the optimal allocation depends on specific client needs and risk tolerance, analysis shows that using annuities as part of a $400,000-$600,000 balance works well for a single person. Where the client s balance exceeds $600,000, the need for an annuity may decrease due to the increased probability of the ABP meeting overall retirement objectives. For balances under $400,000, choices have to be made. For example, very high allocations to annuities may be required to secure basic income needs. Alternatively the client may prefer to leave the annuity allocation small in the expectation that the ABP will perform and meet higher objectives. Client preferences Even a higher balance client may find the features of annuities to be attractive, irrespective of social security considerations. They may utilise a term annuity structure to lock in their discretionary spending profile for the active retirement years. Tools to help you determine and communicate annuity allocations There are a range of tools available on the Colonial First State website that can assist in illustrating and communicating the benefits of annuities to clients, including: Age Pension Calculator Provides an illustration on how the use of annuities can boost entitlement to the age pension. Retirement Income Tool A live quotation tool that allows you to run quotes on both Challenger and CommInsure Annuities. It also provides illustrations on projected retirement income and capital that can help you explain the benefits of using annuities. Visit colonialfirststate.com.au/adviser/platforms/annuities or log in to FirstNet Adviser for more. We re here to help To find out more, please contact your local Business Development Manager, Adviser Services on , 8am to 7pm Sydney time or visit our website at colonialfirststate.com.au/adviser. This document has been prepared by Colonial First State Investments Limited ABN , AFS Licence (Colonial First State) based on its understanding of current regulatory requirements and laws as at 19 January This is general information only and does not take into account any individual objectives, financial situation or needs. Investors should read the relevant Product Disclosure Statement (PDS) before making an investment decision. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including Colonial First State or any member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. This document provides information for the adviser only and is not to be handed on to any investor. It does not take into account any person s individual objectives, financial situation or needs. Advisers need to decide the suitability of each fund based on a person s objectives, financial situation or needs /FS6484/0216 Adviser use only