Monthly Archives: July 2017

Longevity Risk – lifetime uncertainty

Insurance against longevity

Longevity, is one of the imponderables to consider, when one reaches retirement.  This question is how long will you live?  Real problems arise when having contributed into superannuation and now a superannuation lump sum is available to you but, it has to last an indeterminate lifetime. One option available is to apply the lump sum to purchase a guaranteed life annuity.

Starry Night Over the RhoneA guaranteed life annuity pays out every year until, the annuitant specified under the contract, dies.  A life annuity is therefore a compelling product as it “insures” you against longevity—living a long time, and thus risking running out of retirement income streams, while you are enjoying a long life.  A guaranteed life annuity  thus reduces the financial risk that comes with living into old age.

Risk of living too long

An annuitant living too long, beyond normal life expectancy, will accordingly gain from having taken out a life annuity. You will have protected yourself against the adverse financial consequences of longevity.  Guaranteed life annuities are therefore very attractive to the healthy, as an income stream is guaranteed for the whole of one’s lifetime.  Life expectancies for Australians are among the longest in the world and forecast to increase further but generally, people do not appreciate what their life expectancy is. This eliminates some of the financial implications of longevity, but the unhealthy could expect to lose out from buying a life annuity.
The result is that in entering into a life annuity contract there is a fear that the issuer of the annuity will fail, alternatively that the annuitant will die, very soon after taking the contract, the result being a windfall for the insurance company. In any event, the annuitant will lose the outstanding balance of one’s capital at death. Thus taking a life annuity is generally seen as a gamble.

Safety of annuities

However, issuers of annuities are life insurance companies, that are well regulated by the Australian and Prudential and Regulatory Authority, and are required to hold their assets in segregated funds. Furthermore, Life Insurance companies make adjustments to the contracted level of income through margins to run their operations, cover the risk associated with the assets backing the life annuities and to cater for an adverse selection against them were their life annuity products are taken by those who are more healthy than the general population.

Risk of dying young

An option available to purchasers to address the risks they perceive is to take joint and survivor guaranteed annuities. This annuity is issued with reference to the life of the annuitant and a dependant of the annuitant, usually the spouse. The annuity is guaranteed to be payable during the life of both the annuitant and continue for the lifetime of the joint annuitant.
Joint and survivor annuities may be structured to pay a constant amount throughout the lives of the two persons, or alternatively there may be a reduction in the annuity income level after the death of the first dying. This results in higher income levels to be paid initially.

Protecting capital in annuity

Although the focus of life annuities is to address longevity risk you may unnecessarily forfeit your capital if you die prematurely.  To overcome the aversion to possibly losing capital, in the event of premature death, life annuity issuers have been offering a withdrawal guarantee for a substantial portion of the capital for and initial time of up to 15 years.

Does downside protection have its downside?

Further reading:

 

Why choose a SMSF as a saving option

Investing is regarded as complex and confusing right? That’s why you need a financial adviser to help you, isn’t it?

Man Shadow illustrating that costs cast a long shadow

That is true, but the costs of using a financial adviser or even a regular superannuation fund can often erode the investment returns and these costs are often hidden.

Self-managed superannuation fund

While it is probably better to be self-reliant, applying yourself properly to identifying and evaluating investments, takes time and is highly unlikely to result in above average results over the long run.

It’s also risky to not evaluate investments appropriately and act outside your circle of competence.

In Australia however, we have a unique situation that allows hundreds of thousand of small superannuation funds to be managed by their beneficiaries who act as trustees.

In Common Sense on Mutual Funds, John C. Bogle highlights that:

  • although we hear of the benefits of compounding returns we are seldom told about compounding costs or factor this into our long-term plans,
  • very few fund managers achieve market beating returns, especially over the long run, yet they are rewarded with a significant proportion of investment returns,
  • costs do matter and simplicity is the best way to avoid costs

I have realised that for those with the time, skills and discipline there is the opportunity to have more self direction and control over their retirement funds.  On the other hand, those that rely on outside help, will have to pay advisers which will bring them little benefit and cost them dearly in terms of returns on their investment.

The message is clear.  By setting up a SMSF you have the opportunity to eliminate costs by:

  • maintaining a simply structured SMSF, without ongoing professional advice.
  • investing while staying within your circle of competence, achieving appropriate diversification, maintaining high liquidity and staying focused for the long term.

What is an annuity?

An annuity is a financial product paying an income stream to the buyer for a period of time.  The income stream is paid monthly (or quarterly, semi-annually , or annually).

The person receiving the income is usually the buyer or, spouse or, children of the buyer. An annuity contract usually includes a  purchaser, an issuer of the contract, usually an insurance company. When purchased with a superannuation lump sum the recipient of the regular income is restricted to the buyer or spouse.

Purpose of annuity

These contracts are usually intended to pay an income for the life of the person or lives of two persons .  The term of the the income stream may however be fixed, such as 10 years.  When an annuity is arranged for the lifetime of a person the arrangement is referred to as a lifetime annuity.  The term for which the regular payments will therefore be paid for is the uncertain lifetime of the annuitant (the person entitled to the income).  This is the key benefit of an annuity.

Benefits of annuity

The benefit is that the person receiving the income stream will receive a fixed payment over a period of time.  They know exactly how much they will receive and when.  If taken for life then the annuitant cannot outlive the income stream.  If an annuity is taken out to last the lifetime of the persons receiving the income stream and they live longer than expected it will be to their advantage. This is the unique benefit of an annuity—it eliminates the risk of personal longevity.

Risks of an annuity

As the income stream is fixed, with inflation, it will not maintain its purchasing power.  If the person receiving the regular income dies soon after entering into the annuity contract, some of their money will have have been forfeited to the issuer. So there is no protection of income against inflation and there is no preservation of capital.