Retirement income products
Regardless of the design of the retirement income system, it must include a suitable range of products.
There are regulatory and other policy impediments to developing income products with risk management features that could benefit retirees.
Choosing retirement income products necessarily involves trade-offs between income, flexibility and risk management. Australia has an opportunity to introduce new products that could help retirees achieve their desired levels of income, provide them with flexibility and help them better manage risks. Currently, barriers are stifling innovation and adding costs to providers developing new products.
That said, if people have not saved sufficiently during their working lives, they are unlikely to achieve their objectives in retirement with any combination of products.
The range of products
Mercer’s submission notes that the “major shortcoming [of the Australian superannuation system] is in respect of the availability of a broad range of post retirement products that meets the risks faced by retirees”.55 If the goal is to increase the use of products with longevity protection, Australia needs to have an appropriate and affordable range of products.56
Two examples of products that could be useful to retirees are described below.
Deferred lifetime annuities
Deferred lifetime annuities (DLAs) are a form of lifetime annuity where income payments are delayed for a set amount of time. For example, a 65-year-old retiree may purchase a DLA that will provide a steady income stream after the retiree turns 85 and guarantee an income above that of the Age Pension for the remainder of the retiree’s life.
From the provider’s perspective, DLAs insure the most risky period of a standard lifetime annuity. They require significant capital to manage risk. The income efficiency of DLAs cannot be estimated because demand for the product is very low in Australia, although they are likely to be less efficient than standard lifetime annuities. However, DLAs may be attractive to retirees because the commitment of funds for a given income stream declines with the length of deferral. There may be a death benefit payable if the annuitant dies before payments begin, but this benefit would increase the cost of a DLA.
DLAs could be used to complement account-based pensions. Account-based pensions are more income-efficient when drawn down at a faster-than-minimum rate.57 Drawdowns can be structured so that the balance is exhausted, or close to exhausted, at the time a DLA begins to make payments.
In a group self-annuitisation (GSA), participants contribute funds to a pool that is invested in financial assets. Regular payments from the pool are made to surviving members. Pooling mortality risk delivers higher income in retirement than an account-based pension that is drawn down at the minimum rate, while also providing significantly more protection against longevity risk. GSAs allow pool members to share, but not completely eliminate, longevity risk and do not require capital to back guarantees. They can also be offered on a deferred basis like a DLA.
GSA income is not guaranteed like annuity income, but it is expected to be higher due to the absence of capital requirements to back guarantees. The efficiency of the product is 100 per cent (excluding any administrative costs) as the entirety of a pool member’s contribution is expected to be paid as income. Income levels may be lower at older ages if, for example, the entire pool lives longer than expected. Members also lose flexible access to capital and are unable to bequeath residual assets.
Singapore’s Central Provident Fund Lifelong Income For the Elderly (CPF LIFE) scheme has some characteristics of a GSA. Participation is mandatory for those with retirement account balances above a minimum level. Members choose between two plans: one pays a higher income but leaves less for bequests, the other pays a lower income but leaves more for bequests. Payments are not guaranteed to be constant but are designed to be relatively stable; they are adjusted to reflect actual investment returns and mortality.
Other products with longevity risk management features might also emerge if policy settings are changed.
A portfolio of products
Given the different income, risk management and flexibility characteristics of products, retirees with sufficient savings will typically best meet their objectives by using a combination of products and taking some of their benefits as a lump sum. One option, but not the only option, is for an individual to invest a portion of their accumulated funds in a DLA to manage longevity risk. The remainder could be placed in an account-based pension to provide the flexibility to meet unforeseen expenditure needs and offer the potential to deliver higher investment returns (Chart 8.6).
Chart 8.6: Stylised example of annual income for a retiree with multiple income products
Regulatory barriers to product development
For retirees aged 60 years or older, investment earnings on superannuation assets that support eligible income stream products are exempt from tax. Eligible income stream products must comply with the standards in the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations). These standards are designed to accommodate products that provide retirement incomes.58
Several submissions suggest that the rules are too inflexible to allow innovation and new products. Neither DLAs nor GSAs meet the standards set out in the SIS Regulations. In practice, if a product cannot qualify for a tax exemption, the market for that product is highly unlikely to develop. Many submissions call for removing the barriers to product innovation imposed by the SIS Regulations.
Australia’s Future Tax System Review also recommended removing these rules, in conjunction with taxing superannuation assets in both the accumulation and retirement phases at a uniform rate.59
Age Pension means-tests
The Age Pension assets test and income test (through deeming an income on assets) apply to DLAs, even during the deferral period. Several submissions call for an exemption for non-commutable DLAs from the tests during the deferral period. Australia’s Future Tax System Review recommended “given the unique nature of deferred annuities, there is a case that they should only be means tested when they start to pay an income, unless a person can access the capital before this time”.60
Multiple approvals required
Tax and social security settings are major factors affecting demand for retirement income products, as noted above. Providers of new retirement income products must deal with multiple Government bodies for approvals, including the ATO, APRA, ASIC and the Department of Social Services.
Risk management for product providers
Longevity risk cannot be eliminated. It can only be transferred. The burden of managing longevity risk must fall on individuals, pools, insurers or government.
Providers of guaranteed retirement income products, especially long-dated or whole-of-life products, are exposed to interest rate, investment and longevity risk. Mitigating these risks requires using more capital, obtaining reinsurance, or managing them in financial markets, for example, by taking offsetting positions in bond or derivative markets. Due to the long-tailed nature of these risks, capital requirements are high, which increases the price of the products. The lack of very long-dated bonds and longevity bonds in wholesale markets makes it difficult to transfer that risk in financial markets.
Unpredictable systematic longevity improvement, potentially brought about by medical advancements, provides significant uncertainty around future longevity. This explains why capital charges on annuities are high, reinsurers are reluctant to take on the risk and there are no issuers of longevity bonds. If a medical breakthrough were to increase life expectancies substantially, longevity insurance providers could be put under financial pressure. It might be appropriate that only prudentially regulated life insurance companies be allowed to provide guaranteed products.
Providers have extremely long-dated liabilities and could more efficiently manage the resulting interest rate risk by investing in (say) 30-year Government bonds. In recent years, the risk-free Commonwealth Government yield curves (both nominal and inflation-linked) have been lengthened, but only to around 20 years. In part, this is because of limited investor demand for bonds with very long tenors. Several submissions call for the Government to issue longer dated bonds to facilitate interest rate risk management for retirement income product providers. Long-dated government bonds would also support the private provision of longevity bonds.61
Challenger’s submission notes that capital requirements for Australian life insurance companies offering annuities are high by international standards.62 This provides greater assurance to recipients against the failure of the provider. However, it also makes annuities more expensive.
If, after removing barriers to market development, the financial system cannot develop a market to manage longevity risk effectively, there may be a case for Government intervention.
The Government could offer longevity insurance to individuals on a commercial basis, in addition to that provided by the Age Pension. For example, this could take the form of a premium paid at retirement, invested outside the consolidated revenue fund — potentially by the Future Fund Board of Guardians — and used to fund an income stream from age 85.
Australia’s Future Tax System Review recommended:
The government should consider offering an immediate annuity and deferred annuity product that would allow a person to purchase a lifetime income. This should be subject to a business case that ensures the accurate pricing of the risks being taken on by the government. To limit the government’s exposure to longevity risk, it should consider placing limits on how much income a person can purchase from the government.63
However, this policy option would increase the Government’s already significant exposure to longevity risk. This risk would be mitigated if the Government offered a non-guaranteed GSA-type product. Alternatively, the Government could charge an appropriate price for the extra risk it took on.
Policy options for consultation
Removing barriers to product development may allow innovation in retirement income products. UniSuper’s submission notes: “Government regulation over the past 20 years has had as much, if not more, influence on product design than industry-led ideas”.64
One policy option proposed in submissions is to streamline administrative arrangements for assessing the eligibility of products for tax concessions and Age Pension means-test treatment. This may reduce the regulatory costs of product development.
Government could facilitate long-dated interest rate risk management for retirement income product providers and support the private provision of longevity bonds by issuing long-dated Treasury Bonds and Treasury Indexed Bonds — with payments linked to inflation. As long-term interest rates are typically higher than short-term interest rates, there may be a cost to Government of maintaining a longer yield curve. Given its current size, the longevity product market may not be able to ‘digest’ a significant supply of long-dated bonds. These costs would depend on the volume of long bonds issued and market conditions.
The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:
- No change to current arrangements.
- Take a more flexible, principles-based approach to determining the eligibility of retirement income products for tax concessions and their treatment by the Age Pension means-tests.
- For product providers, streamline administrative arrangements for assessing the eligibility for tax concessions and Age Pension means-tests treatment of retirement income products.
- Issue longer-dated Government bonds, including inflation-linked bonds, to support the development of retirement income products.
The Inquiry seeks further information on the following areas:
- Would deferred lifetime annuities or group self-annuitisation be useful products for Australian retirees? Are there examples of other potentially suitable products?
- If part of retirees’ superannuation benefits were to default into an income stream product, which product(s) would be appropriate?
- Will the private sector be able to manage longevity risk if there is a large increase in the use of longevity-protected products? How could this be achieved?
• Should Government increase its provision of longevity insurance? How would institutional arrangements be established to ensure they were stable and not subject to political interference?
- What are some appropriate ways to assess and compare retirement income products? Is ‘income efficiency’ a useful measure?
Access to equity in the home
For many retirees, the family home is their most valuable asset. Equity release products allow consumers to access the equity of a property while retaining ownership. The most common forms of equity release are reverse mortgages and home reversion schemes.65 A number of submissions note the potential benefits to retirees of a growing market for these products.
The reverse mortgage market has grown steadily (Chart 8.7). However, fewer than five lenders currently offer the product, compared to more than 15 lenders before the GFC.66
Chart 8.7: Reverse mortgages provided by ADIs
One issue with releasing home equity is that an individual may later have insufficient equity to fund an accommodation bond for an aged care facility.
The small size of the current market appears to reflect individual preferences and commercial considerations. The market is expected to grow further as the population ages, given the large amount of wealth tied up in dwellings.
The Inquiry seeks further information on the following area:
- What, if any, regulations impede the development of products to help retirees access the equity in their homes?
55 Mercer 2014, First round submission to the Financial System Inquiry, page 1.
56 Superannuation funds cannot directly provide guaranteed products (life insurance companies can). Superannuation funds are able to provide account-based pensions, and would be able to provide GSAs.
57 That is, the expected present value of income in retirement is higher.
58 For account-based pensions, the rules specify that a minimum amount must be paid from the product each year. Other products must meet a prescriptive set of requirements including payments at least annually (which disqualifies DLAs), and restrictions on variations in annual payments (which disqualify GSAs).
59 Commonwealth of Australia 2009, Australia’s Future Tax System Review, Report to the Treasurer, Part Two, Detailed analysis, volume 1 of 2, Canberra.
61 Wills, S and Sherris, M 2010, ‘Securitization, Structuring and Pricing of Longevity Risk’, Insurance: Mathematics and Economics, vol 46, issue 1, Elsevier, London, pages 173–185.
62 Challenger 2014, First round submission to the Financial System Inquiry, page 22.
63 Commonwealth of Australia 2009, Australia’s Future Tax System Review, Report to the Treasurer, Part Two, Detailed analysis, volume 1 of 2, Canberra.
64 Unisuper 2014, First round submission to the Financial System Inquiry, page 6.
65 A reverse mortgage is a credit product that allows a person to borrow money against the equity in the home in return for a lump sum, line of credit or regular payment. A home reversion scheme allows a consumer to sell a portion of their home in exchange for a fixed proportion of the proceeds of the home when it is sold.
66 Deloitte and SEQUAL 2013, Australia’s equity release market — an opportunity being missed, media release, 16 September, viewed 17 June 2013.
67 Australian Prudential Regulation Authority 2014, Quarterly Authorised Deposit-taking Institution Property Exposures, Sydney, March. Includes ADIs with greater than $1 billion of term loans.