Annuities and lifetime income streams: How they work and who they suit

This transcript has been condensed and edited for clarity, with the assistance of Warren Chant and Geoff Warren, so the wording does not always match the conversation in the video.

Today, we’re exploring another important and often misunderstood topic in retirement planning, namely lifetime income streams, also known as lifetime annuities or lifetime income products.

These products are designed to provide income for life, helping retirees manage longevity risk and build confidence that their money will last as long as they do. Yet despite these benefits, only a small proportion of Australians use them, prompting an important question: why?

To unpack this, we’re joined by Professor Geoff Warren from the Australian National University and the Conexus Institute. He is a leading Australian expert in retirement-income design and policy. Let’s start with the basics.

Can you unpack what lifetime income streams essentially are?

Lifetime income streams are financial products that pay you income for as long as you live. That’s it in a nutshell. They’re complex, though, and there are many types. Today, I’m going to unpack them for you and give you a basic understanding of how they work. To illustrate, I’ll use a lifetime income stream (LIS) that pays an inflation-adjusted annual income of $5,000 for life on a $100,000 investment.

It’s best to view them as a composite product that provides a lifetime income stream from three sources:

• Earnings of the underlying investments
• Drawdown of the capital invested
• What we call mortality credits.

The investments may include defensive fixed-income assets, growth assets such as shares and property, or a mix of both. We’ll discuss the implications later.

Mortality credits is a terrible term, coined by actuaries, but so be it. I’ll use it anyway. They work like this: when you invest in a lifetime income stream, your money (capital) is pooled with other investors in the product. Those who die early fund the lifetime income of those who live longer. That’s what gives you income for life.

Those who die early must give up access to at least some of their capital. It’s a trade-off for receiving income for life. Your capital remains in the pool upon your death and is used to fund the remaining pool members.

I believe mortality credits are the secret sauce. The other two components more closely reflect what you would get if you simply invested your capital in fixed-income assets and drew an annual income of $5,000 (inflation-adjusted). That strategy wouldn’t provide income for life. This is the key nuance to grasp.

An LIS seems like a great deal, right? An annual income of $5,000 (inflation-adjusted) for as long as I’m alive. But you have to be willing to give up some of your capital when you die. It passes to the remaining pool members. This is the trade-off for receiving a lifetime income.

Lifetime income streams take many forms. Can you outline the main types and their key features?

Yes, there are different types of income streams. A key point of differentiation is how your income is indexed each year. There are three main types of LIS:

• A fixed nominal income that remains the same each year
• A fixed real income that is adjusted for inflation each year
• An investment-linked income that varies each year with the performance of the underlying investments, typically including growth assets such as shares, perhaps within some mix of growth and defensive assets.

Broadly, when you invest in fixed-income assets, you know the return you’ll get. But with investment-linked products, returns are uncertain and are expected to be higher than those of fixed-income assets because the underlying investments include growth assets with higher expected returns.

Investment-linked products are better suited to people who want insurance against outliving their savings (longevity risk) and also want to invest a bit more aggressively to hopefully receive higher income payments, but are willing to accept a variable income stream.

It’s similar to what happens if you simply invest your funds in an account-based pension. You could invest in defensive assets, which will give you a relatively low income but with low volatility (risk). Alternatively, you could invest in growth assets, which could provide a relatively high income but with higher volatility.

The same logic applies to lifetime income streams. The best way to think about them is that they are underpinned by investments, which may be fixed-income assets, growth assets, or a mix of both. They also benefit from mortality credits. That’s why I call lifetime income streams composite products.

Another product differentiation is the timing of income payments. You can start receiving payments immediately or defer them to a later date, such as age 85 or beyond.

With a deferred annuity, you typically receive a much higher income for each dollar invested because you pay up front and don’t receive income until later. There’s also a lower chance you’ll be alive to enjoy that income. But if you are, your income will be much higher. Deferred annuities can be useful to ensure income is available if you happen to live to a very old age.

In essence, you could use your account-based pension to see you through to, say, age 85, and then rely on your deferred annuity for income for the rest of your life. By contrast, an immediate annuity provides you with an additional layer of income from the outset.

Another common product feature is a spouse reversionary option. This option allows income payments to revert to your spouse upon your death, with payments continuing to them until their death. Some products also allow you to reduce the level of payments to your spouse.

With a reversionary option, you are offered a lower income than if it were just for yourself. This is because there is a lower likelihood of money being left in the pool to support the others earlier on, with any such money likely to be left later on after your spouse dies.

Another distinction is the type of product provider. It could be a life insurance company, such as Challenger, Generation Life, or Allianz, or a super fund. Australian Retirement Trust (ART), AMP, Colonial First State (CFS), MLC and UniSuper currently offer lifetime income streams, and other funds are working on products. Insurance companies guarantee income payments, except with investment-linked products, where they guarantee income for life but not the amount.

Life companies must pool annuity capital in a statutory fund and invest their own capital in it to ensure they can meet all their promises to annuitants. They are regulated by the Australian Prudential Regulation Authority (APRA). Importantly, their pricing includes a profit margin.

In profit-for-member super funds, all the risks (investment and longevity) could be shared among members in the pool. This means that if members in the pool live longer than the income sums were based on, some downward adjustment in income is required, otherwise there will be insufficient funding (that is, lower mortality credits) to sustain the level of income payments.

However, this is generally a cheaper way to insure because the fund does not include a profit margin in its pricing, unlike life companies or retail super funds.

There may be Age Pension impacts. It is possible to get an uplift to your Age Pension if you’re in the Age Pension ‘taper zone’. That is, you qualify for the Age Pension but aren’t receiving the full amount, so you’re on a part pension. The exact amount of additional pension is complex to determine, but it can be meaningful.

A final point. Sometimes there is differential pricing for males and females. That simply reflects the fact that, on average, females live longer, so they’re more likely to leave capital in the pool later than males.

There are many features, and I haven’t covered them all. But I believe I have covered the key ones.

Is it also the case that only 60% of the value is counted under the Age Pension assets test? Is that correct?

That’s correct. It counts as 60% of the purchase price, but reduces to 30% after age 84. This means that those in the Age Pension taper zone get an immediate uplift from buying a lifetime income stream versus investing in an account-based pension. But the relative benefit changes over time. The income test may also come into play at some stage. As I said, it’s complex.

I understand the 60/30% discount was designed to balance the treatment of lifetime income streams and account-based pensions. With annuities, you invest a lump sum but do not have an account balance. The 60/30% discount reflects that your initial investment declines over time.

You mentioned the need to commit capital as part of the deal. People are receiving income, but does that mean they can never access those funds again? Could that be an issue for some people?

That could be an issue for some people. Your need for access to your capital is an important consideration. However, most of these products offer death and withdrawal benefits. Let me explain the implications.

A death benefit means that when you die, any remaining capital is paid to your partner or the beneficiary you nominate. A withdrawal benefit allows you to withdraw any remaining capital if you exit the product. Partial withdrawals are rarely permitted.

Clearly, if you choose to have a death/withdrawal benefit, there may be less money to contribute back into the pool. To compensate, you’ll receive a lower income. However, the benefits you can receive in a superannuation context are limited, as set out in the legislated Capital Access Schedule (CAS). You can find it on the Centrelink website or the Department of Social Services (DSS) website.

CAS sets out a sliding scale for how much capital can be returned to people, ending at life expectancy, which is around age 85. This means you can get some capital back earlier on, but the amount gradually decreases. By the time you reach life expectancy, you can’t get any back.

All this makes me wonder whether access to capital from the lifetime income stream is really needed?

Maybe not. Most of the time, people don’t put all their assets into a lifetime income stream. In my view, they shouldn’t, and should be allocating their assets between a lifetime income stream and an account-based pension. The account-based pension provides flexible access to funds.

Personally, I wouldn’t opt for the death and exit benefits. I’d want to maximise my lifetime income stream and then rely on my account-based pension for flexible access to funds, taking into account that it will be drawn down over time.

Ask yourself why you need access to funds via a lifetime income stream when it is only available earlier in retirement, when your account-based pension has not been run down and the likelihood of death is low. And ask yourself whether in later years you may be content with your account-based pension income, any Age Pension and income from a LIS. If you’re happy with that arrangement, you may not need death and withdrawal benefits.

However, all providers offer death and often exit benefits because they’ve found people won’t invest in a LIS without them.

This all comes down to what I see as ‘narrow framing’. People view the lifetime income stream in isolation as a product and say, ‘I am not going into a product where I can’t get my capital out and it goes to the provider if I die early. And that’s the end of the story.’

The offer of death and exit benefits is meant to provide some comfort. If you die tomorrow, you’ll get something back, or at least your beneficiaries will. And you can get your money back if needed.

What do you consider the advantages and disadvantages of lifetime income streams to be, and which types of retirees might benefit from allocating to them?

I’ll discuss the advantages first. The first one is obvious. It’s income for life. It provides a floor for your income, reducing the risk to your income level and its sustainability. I suppose the emphasis here is on sustainability, because it’s income for life.

You can manage the risk to your income level with a fixed annuity. If it’s an investment-linked annuity, you still have some risk around your income level, but you also have the potential for a greater upside in income. That’s the surprising bit that I don’t think is well understood.

There are three reasons why an investment-linked annuity can actually boost your expected income relative to investing in an account-based pension.

First, mortality credits provide income if you live a long life.

Second, because you have income for life, the back end of your life is taken care of, so you can afford to draw more income earlier, when you’re more likely to enjoy it. You’ll no longer need to be conservative when drawing down to make sure your assets and income last the distance.

Third, there is less fear of running out of money, which is a benefit in itself. You’ll probably be more confident and willing to draw more to spend earlier on.

Now, the disadvantages. First, you’re committing capital, which reduces your flexibility to deal with unforeseen events. You’re locked into the product to a substantial degree. Even if you can exit, it will cost to do so, and it’s often just a hassle as well.

Second, you reduce the inheritance you leave behind. If you live beyond life expectancy, say, age 85, there won’t be any inheritance left.

Third, some people may be concerned about whether the provider will still be around in 30 or 40 years. However, an insurer is required to hold capital, and if it closed up shop, it would likely hand the book over to another insurer.

Finally, there may be embedded costs that are not visible. You may never know how good a deal you are getting because you don’t have visibility into how much you’re paying for the product.

Weighing up those upsides and downsides, how big is the potential upside?

The chart shown in the video tells the story very well. It considers a lifespan of 109 years. The black line shows the income you would expect. The grey lines show the range of incomes you might expect, spanning from 1% to 99%, which covers nearly all possible outcomes.

On the left, we show the income you receive if you have 100% of your money in an account-based pension invested in a 60/40 balanced option. On the right, we show a strategy that allocates 50% of your money to an account-based pension and 50% to an LIS.

In both cases, the underlying investment is a 60/40 balanced option. The difference is that in the 50/50 strategy, I’ve added in mortality credits. The income in the chart on the right is higher and more stable, and it doesn’t run out towards the end.

Essentially, what’s happening is that you get a higher expected income because the mortality credits operate as an additional source of ‘returns’, which allows more income to be drawn.

These examples haven’t taken into account the Age Pension benefits either. If you did, the 50/50 strategy would be even better. Of course, the cost is that you have to trade something off, and that’s access to capital. What you need to ask yourself is whether you’d rather invest 100% of your money in an account-based pension, with full access to capital, or a 50/50 strategy, in which case you’d give up access to some of that capital.

The 50/50 strategy even delivers higher income if you only live to 85 or 90. Note how income in the first part of the chart is higher on the right than on the left. You get more expected income earlier because there is more capacity and confidence to draw down, because if you survive you’ll still have income later. You don’t have to hold as much back, just in case.

The chart on the right has a 50% lifetime income stream. Has there been any research into what the optimum might be, or is there a typical range for how much to allocate to a lifetime income stream?

It will differ for the individual, depending on how they balance having income for life versus access to their capital. But for most, some sort of mix may be appropriate. There is also the question of whether they prefer lower but guaranteed income through a fixed annuity or higher but variable expected income through an investment-linked annuity.

Which types of retirees might benefit from at least considering these lifetime income streams?

First, I’d say most retirees would benefit from a higher expected income. Bear in mind, I’m talking about a higher expected income for a given asset mix that underpins it. I believe these products are worth considering, though they’re more beneficial to some than to others.

Those who want a guaranteed income for life should give it strong consideration. For people who want flexible access to funds or think their circumstances might change, it might not be so attractive. In that case, you might invest only a small amount, if anything at all. It all hinges on how you feel about the trade-off between losing some access to funds and leaving an inheritance, and having security for the remainder of your life. I think that’s really the nub of it.

Another thing to consider is how long you expect to live. If you reckon you have a good chance of reaching a ripe old age because your parents did and you’re very healthy, it’s probably a better deal for you than if you’re suffering from heart conditions or diabetes and aren’t likely to live as long.

There is also the issue of whether you need a guaranteed minimum income, for example, to pay the rent. You might say you need a fixed lifetime annuity that provides a guaranteed level of income to make sure you can get through, rather than an investment-linked annuity. Again, that would be a personal decision.

Do you happen to know, percentage-wise, how many retirees in Australia might have purchased these?

Very small. Take-up has been very low. Single digits, although I don’t know the exact number. This is well known around the globe. Academics call it the annuity puzzle. If you put an annuity or a lifetime income stream in your model, it always comes back saying ‘hold some’. But most people don’t.

That raises the question of why they don’t. In our explainer on lifetime income streams, we cite 38 reasons given for why people don’t take up annuities, some more plausible than others.

For me, there are three main ones. First, people don’t understand them, so they don’t buy them. They’re complex products that haven’t been explained to them.

Second, they’re often framed as an investment product. People may say, ‘I’m making this investment, and if I die tomorrow, I’ll get nothing back. That sounds like a bad deal.’ Framing them differently, as products that give you a guaranteed income for life and protect against longevity risk, might lead to greater take-up. Studies show that describing annuities in terms of what they do leads to much more interest from people.

Finally, it’s about how they’re offered. For people to take up lifetime income streams, they need to purchase them. Many don’t. They have to click on the product and investigate it, and they run into problems like lack of understanding and complexity. Advisers haven’t always recommended them for various reasons, including concerns about giving up access to the funds.

For me, the real way to get more value from lifetime income streams is to offer them as part of an integrated retirement solution. What if a super fund told its members, ‘The solution for you is to have this much in your account-based pension and so much in a LIS. This is your drawdown strategy. And we’re going to put it all together as a package and deliver it to you.’

I believe you’d see much greater take-up because people would view it as a recommendation from their fund and give it serious consideration.

What is the super industry in Australia actually doing? Which funds offer lifetime income streams, and what are the products like?

I understand you’ve done a piece on this at SuperGuide, Robert. Is that correct?

Yes, we have. We’ve compiled a list of super funds that offer lifetime income streams. I’d recommend everyone check it out.

At this stage, only a small number of super funds have their own products, including two profit-for-member funds, Australian Retirement Trust and UniSuper, and a handful of retail funds. Products are also offered by three life insurance companies: Challenger Life, Generation Life and Allianz Retire+. However, there’s significant activity, with super funds developing their own products, often in conjunction with an insurer to cover longevity risk.

We also see a significant difference in what super funds offer their members. The profit-for-member funds, Australian Retirement Trust and UniSuper, offer very basic products. For example, ART offers a basic investment-linked annuity that invests in its balanced fund, while UniSuper offers a fixed real annuity. Some retail funds include life company products on their platforms, while others offer a badged life company product.

Another trend is the offering of these products through advisory platforms. This results in highly complex, high-functionality products that allow financial advisers to tailor them to a client’s specific needs. You can choose whether to include a death/withdrawal benefit, and advisers can select the underlying investments from a wide range of options. These products are offered only through financial advisers.

Then there’s Challenger Life. It offers straightforward products with few bells and whistles. You can buy its products directly; you don’t need a financial adviser to do so.

Do you think people perceive annuities as expensive? Do you think that’s fair or unfair? Is it due to a misunderstanding about the fees or their visibility?

The true cost of the products is not very visible, as the costs don’t just appear as explicit fees but may also be embedded elsewhere, such as in the level of income paid. There is a risk that if people don’t know the true costs, they may tend to assume they’re being ripped off even when that’s not the case.

I would judge a product’s value by whether it improves my overall financial position in retirement, all things considered. You’ll know the terms and conditions. If you purchase a fixed annuity directly from Challenger Life, for instance, it will give you the rate straight up. You’ll know exactly what income you’ll receive for life, either in nominal or real terms. The question to ask is whether this is a good deal for you.

In Australia, most lifetime income products have been purchased through a financial adviser. We are only now seeing the potential for them to reach a much broader market through super funds. So there’s likely to be much greater explanation, visibility and transparency around these issues emerging over time.

For now, people are flying blind in a complex area. For me, the ideal situation is when super funds can recommend a lifetime income stream as part of an integrated, comprehensive solution that meets an individual’s financial needs in retirement.

Well, thanks, Geoff. Thanks so much for all the insight today. I think it’ll help a lot of people.

It’s a pleasure.