Retirement incomes III: deconstructed annuities

In this series of Trialogues on retirement incomes we have run through a range of product propositions available to providers; first came account-based pensions (where all the money is), followed by guaranteed income solutions (variable annuities).  In this, the third and final instalment, we look at non-guaranteed options which we’ve called ‘deconstructed annuities’ for reasons that will become clear.

These products are manufactured using the same capabilities as annuities, but without the guarantee over either the capital value or income level.  Here we pull apart two varieties:

‘Naked risk pooling’ (lifetime annuities deconstructed)

Lifetime annuities are made up of three elements: risk pooling, investment strategy and a guarantee.

• Risk pooling is all about how long people live.  By pooling the risk of individuals living too long and running out of money with those who live shorter lives those who live shorter lives subsidise those who live longer ones.
• Then the capital has to be invested through an investment strategy, generating a return.
• Finally, there is a guarantee.  A life company is contracted to deliver a set level of income each year for the rest of an individual’s life.

As an individual holder of a lifetime annuity however, you do not have exposure to the risk of everyone living longer or investment returns being lower than anticipated.  You simply receive an income, for life.  Any change in life expectancy is the life company’s risk.  Likewise any period of sustained investment losses.  That’s what the guarantee is for – it provides near-absolute certainty.
 
The deconstructed version of a lifetime annuity (Mercer’s Lifetime Plus product is the most prominent example) has only the first two elements – there is no guarantee.  So although risks are pooled and those who live longer will have their incomes paid for by those who lived shorter lives, if everyone lives longer, incomes will suffer.  Of course, painstaking actuarial assumptions are used to balance that equation, but should they get it wrong (and people live longer than expected), without a life company backing the product, the risk is on the investors.  And, of course, you have no way of knowing the risk you are taking on – because you have no idea who the other members are (or even how many of them have invested, and therefore how diversified your risk is).
 
Further, if investment returns are lower than forecast, all else being equal the income payable to investors will be lower as well.
 
‘Naked income guarantee’ (variable annuities deconstructed)
 
Guaranteed lifetime income products (otherwise known as variable annuities) have three elements as well: an investment strategy, a guarantee and a hedging strategy to offset the provider’s risk.

• The Investment strategy is the customer portfolio of investments, generally a balanced portfolio of managed funds.  Some products, such as AMP’s North, allow quite a bit of flexibility in choosing investments while others are more restrictive.
• A guarantee over either the capital value of the portfolio, or (in pension mode) the payment of a minimum income stream for life, regardless of actual investment returns.
• A hedging strategy that aims to ensure negative investment returns (which would otherwise require the life company to ‘pay in’ to meet its requirements under the guarantee) are offset by gains in derivative contracts.  This is done on the life company’s balance sheet, and is not visible in the customer’s portfolio.

The deconstructed version of a variable annuity is similar but again without the guarantee.  So you get the benefit of the investment strategy (your choice of investments with some potential restrictions) plus an institutional-grade hedging overlay that cushions the downside, smoothing the investment ride.  The best known example of this offer in Australia is the Milliman / P2 strategy.
 
The point we made last week is that guarantees are expensive – you can’t expect a life company to take on investment risk for free and we all know putting risks on a balance sheet is expensive. 
 
The difference with deconstructed products is that customers benefit from much of the institutional-grade smarts that life companies deploy, but without the actual guarantee, meaning these products can be more than 150bp cheaper than their guaranteed siblings.
 
You can expect to see a wider range of ‘naked’ or deconstructed annuity offers available in Australia as product manufacturers and super funds make calls on the retirement income solutions most suited to their customers.  Time will tell if customers really value the guarantee that sits across the top of the products’ other elements, or if they would rather take the risk themselves.
 
Each part of this three part series has looked at product solutions for retirement, ranging from the simple, popular account-based pensions to more complex, expensive solutions for retirement income streams that provide more certainty. Customers to date have clearly voted for simplicity and control over certainty. Yet it is clear more complex solutions are required to substitute or complement account based pensions if the industry is to meet the challenge of successfully reorientating from accumulating capital balances to generating income streams. The good news is we are not beginning from a standing start – we are seeing a substantial amount of exploratory product development that will produce more choice for customers. The next challenge will be in communicating the benefits of complex retirement solutions to customers simply (and in some cases managing perceptions of higher cost).