Risk of Living too Long negated through life annuity
Ensuring retirement income stream over remainder of one’s life is the key purpose of the superannuation system. The benefits of taking out a life annuity are explained but, for the reasons given below, it is quite rational, that people in Australia decide not to purchase an income stream in the form of an annuity.
The provision of the Australian Government Age Pension provides the ultimate protection against longevity. This leads one to avoid the more costly approach, the purchase of a life annuity, to cover one’s risk of living too long and thus running out of retirement income. A generally conservative investment strategy and margins deducted from returns detract from the efficiency of life annuities by reducing returns.
Conservative investment strategy
To provide a long-term income stream for life, requires the issuer of a life annuity to invest in assets that are highly likely to be around in many years’ time. These assets are therefore required to be secure and accordingly have a commensurately lower rate of return.
Margins to cover capital charges
The issuer of a life annuity is required to hold capital, to offer the protection against risks, insolvency and liquidity, and the providers of such capital require a return on their capital. Margins are therefore taken out of the asset returns, to compensate the providers of capital, reducing the return available to the life annuity holder.
Margins to cater for improvements in life expectancy
The uncertainty of improvements in the life expectancy of the general population is a risk that is borne by the issuer of life annuities. An additional margin therefore has to be allowed out of the returns on all assets to allow for this possibility.
The lower returns from the conservatively invested assets and the margins deducted from such returns results in lower income streams while the risk of the annuity provider failing remains with the owner of the annuity.
In early retirement, while well-being allows for a full lifestyle, the life annuity holder will under spend, and not have access to capital. Conversely, in very old age when lifestyle needs are far lower the annuity income remains and access to the Age Pension is also available. Thus the life annuity has come at a very real cost to the holder by having invested conservatively, carried all the margins to compensate the life annuities issuer for the risks. The net result of funding retirement income through the use of a life annuity results an under spending in the early years of retirement and then when lifestyle needs reduce significantly, at very old age, a level of income remains that cannot used, other than to leave by way of bequest, which is not the purpose of superannuation.