The longevity product puzzle – Are deferred lifetime annuities the answer?

Written by Michael McAlary

Will Deferred lifetime annuities (‘DLAs’) prove to be the next breakthrough product from investment managers, super funds and retirement planners.

The government recently announced a proposal to make DLAs legally purchasable using superannuation money from July 1, 2014.

If the proposal is passed by parliament and implemented, DLA’s will be an invaluable tool in retirement planning and a significant new product for an expanded group of investment managers, especially fixed interest and outcome based investment specialists.

Targeting longevity risk

To date, no one has come up with an ideal post or late retirement investment product. Suggested solutions involving risk parity funds, dynamic asset allocation or longevity insurance each have pros and cons in meeting financial and emotional needs.

As foreshadowed by the Cooper Review, there is no question longevity risk is a major and growing concern for Australians.

Retirees, policy makers and fund managers can see the critical economic need for an individual’s retirement savings to:

• Last as long as they do
• Provide for an adequate living standard until they die

However, in the real world, solutions to such retirement planning issues are complicated by rational considerations, as well as psychological or emotional biases, including perceptions about:

• The amount of longevity insurance needed, value for money and pricing,/li>
• Concerns about short term asset price volatility
• Attitudes to leverage, liquidity and fees
• Provider solvency risk and investment manager skill over the long term
• Entitlement to the age pension
• Estate Planning

Uncertainties related to what may be practically needed as we age, especially in late retirement.

What is a deferred lifetime annuity

Known as a qualified longevity annuity in the US, where they have been available for a number of years, a DLA is basically a form of insurance to cover the costs of living a long time. It involves an up-front premium with payouts that begin in the future.

For example, an age-85 longevity annuity may be purchased at age 65 for a modest sum (say $20,000) with payouts commencing only when and if the purchaser reaches age 85 (They are essentially immediate annuity contracts without the initial payouts).

A combination of the time value of money and the pooling of the premiums by the provider (only policyholders who live long enough receive the income payments) make this a good deal. A decent income can be expected from these products for those fortunate enough to live longer than current expectations and are consequently subjected to living costs for those extra years.

Issues & solutions

Berkeley Emerson Corporate believes DLAs could well prove to be a breakthrough product segment as the population ages. Their potential to create a partitioned retirement where market-linked products, such as an account-based pension, might be required for a known period (e.g. from age 65 years to 85 years) after which the longevity insurance contract is called upon, is significant.

While a DLA is not a completely novel concept, for fund managers and insurers the following issues are well worth considering:

• Is a DLA best used with a growth oriented retirement portfolio, risk parity approach or defensive strategy
• What will be the value for money tipping points for Australian baby boomers?
• Is a DLA an emotional purchase for a 65 year old?
• Competitive pricing and ongoing management of DLAs, given assumed interest rate behaviour and morality rates, will obviously be critical to success. Who can develop a competitive advantage here?
• Does the provision of a cash flow stream in late retirement go far enough? Could the offer provide for certainty of care in old age where a longer life and quality of life may not correspond or where the cost of care is higher than anticipated?
• Is investment in a DLA is akin to transitioning the life insurance component of a financial plan during the accumulation phase into longevity insurance during early retirement in preparation for late retirement?
• How does a DLA compare with immediate annuity and is a DLA ‘for everyone’?

Many people feel vulnerable in retirement. Rationally, retirement should not necessitate an automatic transition to a defensive investment strategy.

However, as evidenced by the GFC years, many retirees feel extreme stress during periods of market volatility or low nominal returns. Any solution must recognise such emotional elements of longevity risk.

From a purely strategic perspective, a product that essentially provides the capacity for both certainty and choices in late retirement that would not be available if solely relying on the government pension safety net, addresses a significant and growing need.