The Annuity Puzzle
It is commonly accepted that lifetime annuities offer retirees a way to protect against longevity and investment risk, however, few buy an annuity with their retirement savings.
This is known amongst behavioural economists as ‘the annuity puzzle’. Many authors have attempted to solve the puzzle, but while they continue to speculate, observations of market behaviour demonstrate that, on the whole, retirees in Australia and abroad are not buying.
Where previously the UK was a success story for the annuities sector, the landscape changed radically this year with a budgetary announcement that has drawn the final curtain on incentivised and compulsory annuitisation.
This article discusses the annuity puzzle in the context of the Australian and UK retirement income markets.
SOLVING THE ANNUITY PUZZLE
In 2012, the Actuaries Institute published a discussion piece, Exploring barriers to Australia’s annuities market1 which cited four key reasons why retirees do not annuitise, these being:
- lack of consumer awareness of the value of annuities at removing key risks;
- behavioural factors, including perception that annuities are expensive, loss aversion, fear of unexpectedly dying early, fear of not living long enough to get back their initial investment and the assumption the aged pension is a suitable fall back option;
- lack of incentives or compulsion; and
- legislative and political barriers, including barriers to product innovation.
Behavioural factors were also cited in the University of New South Wales Centre for Pensions and Superannuation 2008 paper, Australia’s disappearing market for annuities.2 More specifically, retirees view their pension savings as an investment rather than a means to fund future consumption. Other reasons cited in this paper follow a similar logic, for example, concern that annuity products do not provide a return of capital and wanting to bequeath assets.
Economic theory relies on the assumption that individuals behave in a rational manner. In fact, behavioural economics was born out of challenging this assumption.
Both economists and practitioners agree that, on average, retirees purchasing an annuity makes sense from the perspective of managing investment and longevity risk. However, consumer behaviour clearly demonstrates that individual retirees do not view themselves as average. Information asymmetry and anti selection come into play here with annuities therefore representing the ‘best value’ for retirees who perceive themselves as being in the ‘best health’.
DESIGNING AWAY BEHAVIOURAL FACTORS
Australia’s two annuity providers†, Challenger and CommInsure, through product design attempt to subdue annuitants’ fears of losing their money if they die early. Challenger offers a 15 year withdrawal period on its lifetime annuities. This option also pays a lump sum to an annuitant’s estate on death within this period. Similarly, CommInsure allows annuitants to withdraw during a guarantee period. In the event of death, the estate can either continue to receive annuity payments for the remaining duration of the guarantee period or receive a lump sum.
Annuitants can increase their regular annuity payments by passing up these guarantees. Retirees, therefore, need to weigh up whether certainty in exchange for the regular income forgone represents value for money for their individual circumstances.
THE END OF INCENTIVES AND COMPULSION IN THE UK
In March 2014, the UK government announced the abolishment of tax restrictions, paving the way for pensioners to withdraw their pension pot as a lump sum rather than having to purchase an annuity. This follows the removal in 2011 of the requirement to purchase an annuity at age 75, previously known as compulsory annuitisation.
Presently, lump sum withdrawals above the tax free amount are taxed at 55%, which provides a strong incentive for retirees to purchase a retirement income stream product, with three quarters choosing an annuity. From April 2015, these lump sum withdrawals will be taxed a retiree’s marginal rate.4
Markets reacted decisively to this announcement with share prices in the two leading underwritten annuity providers, Partnership Assurance and Just Retirement, falling 53% and 43% respectively in one day of trading.5 These two specialist companies represent over 50% of the market share of the UK underwritten immediate lifetime annuities sector.
Furthermore, according to the Association for British Insurers (ABI), annuity sales volumes fell by over a third between the first and second quarters of 2014, or more specifically, between the quarters pre and post the budget announcement.6 The specialist providers have seen even greater reductions, with both Partnership and Just Retirement quoting a fall in sales volumes of around 50% compared to the pre-Budget period.7,8
While the outlook for UK annuities is uncertain, optimists view this as being on the edge of retirement innovation. Currently, providers, in particular annuity specialists, are working tirelessly to evolve their business to find new and innovative ways to continue to receive a slice of the USD 3.3tn9,†† pension assets pie.
Australian retirement specialists would be well placed to monitor the transformation of this market, as it provides first hand insight into the impact of compulsion and incentives on annuity sales. Lessons learned here could be used to help shape the future of the Australian retirement income sector.
A WAY FORWARD FOR AUSTRALIA
In August, the Actuaries Institute submitted a response to the Financial System Inquiry (FSI) interim report reiterating key recommendations, including that the Government:11
- adopt a comprehensive framework to manage all issues relating to a sustainable financing of our ageing population;
- establish a mechanism to develop, coordinate and drive retirement income policy;
- create an open data regime to allow increased access to relevant Government held data and modelling information to better manage macro risks to the financial system; and
- remove regulatory and other policy impediments to developing retirement income default options and a wider range of annuity products with risk management features that could benefit retirees.
The Institute followed this in September with a submission to the Treasury12 which responded to consultation questions raised in the Treasury’s discussion paper, Review of Retirement Income Stream Regulation13.This submission focuses on removing legislative barriers that prevent the development of innovative retirement income stream products.
Several of Treasury’s questions focus on deferred lifetime annuities (DLAs), as the Government is considering broadening annuity and pension rules so as to extend ‘to DLAs the same concessional tax treatment that applies to investment earnings on assets supporting superannuation income streams’.
ARE DEFERRED LIFETIME ANNUITIES THE ANSWER?
A DLA is an annuity that is purchased with an up-front single premium, but where regular income payments commence after a deferment period and continue for life. The deferment period may be a particular age, for example, 85 years or the annuitant’s life expectancy.
Both economists and practitioners agree that, on average, retirees purchasing an annuity makes sense from the perspective of managing investment and longevity risk. however, consumer behaviour clearly demonstrates that individual retirees do not view themselves as average.
These products serve the purpose of managing longevity risk, but are also considerably cheaper for consumers than immediate annuities. As such, they may represent a closer fit to consumers’ needs and wants.
A key issue for insurers developing these products is access to credible data from which to develop mortality assumptions, especially at older ages. In addition, insurers may not have the necessary tools or information to be able to underwrite lives and so may have to rely on cross- subsidy and costly contingency margins. Underwriting can help make annuities more cost effective for retirees by attempting to price commensurate to an individual’s risk.
The timing of emergence of profit may be another consideration for Australian insurers, as using annuity payments as a profit carrier defers the release of planned profits.
CONCLUSION
UK insurers will find out just how resilient annuity sales are in April 2015 when tax rates on lump sum withdrawals and income stream products are equalised. The market’s initial reaction suggests that, without penalty tax rates, retirees are unlikely to purchase immediate lifetime annuities.
The Australian Government is considering extending to DLAs the same concessional tax treatment that applies to other retirement income stream products in an attempt to encourage retirees to self manage their longevity risk. This begs the question as to whether this is enough to entice sales.
It would appear that the most effective way to sure up sales of income stream products is to impose penalty tax rates on lump sum withdrawals, but does this have to be an all or nothing proposition? Could a Government steer individuals towards insuring against longevity risk by legislating that a proportion of retirement benefits be annuitised? This scenario would leave spending of the remaining funds at the discretion of retirees.
Whether or not the Australian Government introduces compulsion or incentives, what does appear clear is the importance of understanding retirees’ needs and wants, and in doing so, designing products that consumers perceive as representing greater certainty of value for money. Time will tell if DLAs are one such option.
†For FY2014, Challenger’s lifetime annuity sales were $613m, “up 139%, and more than the entire annuity industry has sold in any year.”3 While Commbank publishes sales results for Comminsure separately, results are not split by product line.
††As at end 2013, Australia’s total pension assets were USD 1.6tn, comprising 84% defined contribution. UK pension assets of USD 3.3tn include both defined benefit and defined contribution.9 Defined contribution assets estimated as USD 0.5tn.10
REFERENCES
1 Howes, M. (2012). Discussion paper exploring barriers to Australia’s annuities market. Actuaries Institute.
2 Bateman, H. and Ganegoda, A. (2008). ‘Australia’s disappearing market for life annuities’. University of New South Wales, Centre for Pensions and Superannuation.
3 Challenger Limited. FY14 results.
4 HM Treasury. Budget 2014: greater choice in pensions explained.
5 http://markets.ft.com/research/markets/Overview
6 Association of British Insurers. ABI statistics Q2 2014: The UK retirement income market post-Budget.
7 Partnership Assurance. (14 Aug 2014). Interim results for Partnership Assurance Group plc (‘Partnership’) for the half year ended 30 June 2014.
8 Just Retirement. (18 September 2014). Just Retirement Group PLC Results or the twelve months ended 30 June 2014 resilient operating performance.
9 Australian Government, Australian Trade Commission. (20 February 2014). Data Alert: Australian pension funds growth the world’s highest.
10 Office of Fair Trading. (September 2013). Defined contribution workplace pension market study.
11 Actuaries Institute. (25 August 2014). FSI Interim Report – Actuaries Institute Submission.
12 Actuaries Institute. (22 September 2014). Review of retirement income stream regulation.
13Australian Government. (July 2014). Review of retirement income stream regulation.
CPD: Actuaries Institute Members can claim two CPD points for every hour of reading articles on Actuaries Digital.
