Are annuities bad, or just misunderstood?

PORTFOLIO POINT: New research is showing that annuities are not getting traction among retirees, despite increased longevity risk. Are annuities bad, or just misunderstood?

Former Prime Minister Paul Keating, the father of Australia’s superannuation system, this week brought the subject of longevity and retirement firmly back into the spotlight with the opening address at the Association of Superannuation Funds of Australia conference in Sydney.

Keating had plenty to say about the current system – he criticised the reduction in the contributions cap for people over 50, said the self-managed superannuation sector had unrealistic expectations about returns, and reportedly claimed at least $600,000 in assets was needed to make self-managed funds a better proposition than a major fund.

But he also urged the increase of the compulsory salary contribution (known as the Superannuation Guarantee) to as high as 15%, in order to deal with “superannuation phase two” – or the years over 80 when some people may have already been retired for several decades. Keating suggested the money from the extra 3% of income above the current planned rate of 12% by 2020 could go toward a “longevity insurance fund”, effectively helping the government pay for the universal lifetime annuity that is the age pension. (At present the SG rate is 9%).

Curiously, though Keating berated both institutional fund managers for poor performance and questioned the ability of almost one million Australians who are now members of DIY funds, there was little mention made of annuities. Nevertheless, annuities have been seen as a very useful option for investors who may not wish to actively managed their DIY funds or leave their retirement exposed to the markets in managed funds.

Robert Gottliebsen has been canvassing the attractions of annuities for some time now (Annuities look good again), writing that if the competition and range of options improved, the experiences of those who retired in the global financial crisis would see annuities come back into fashion.

But, if annuities are such a great idea, why is hardly anyone using them already? New research just released suggests it could be due to a lack of understanding about how they are valued.

Annuities, for those unfamiliar, are a retirement product where (in the simplest form) an up-front payment is exchanged for small amounts of money to be paid out over time – usually for the remainder of the annuity-holder’s life.

And one could be forgiven for being unfamiliar, since only a tiny percentage of Australians are taking them up. Roughly $3 billion went into annuities in 2011, and surveys indicate only about 5% of retiree’s assets are invested in annuities – retirees that will soon make up more than 60% of Australia’s multi-trillion-dollar superannuation pool.

The depth of both absence, and misunderstanding, of annuities in Australia’s retirement system was revealed in a Rice Warner report released this week, which was commissioned by the SMSF Professionals Association of Australia (SPAA) and Vanguard.

The survey of self-managed super fund (SMSF) members – sourced through SPAA and Vanguard – found significant negative attitudes toward annuities. Just two respondents out of almost 400 reported holding an annuity and none held a deferred annuity.

The majority did not hold annuities, had no intention of holding annuities, and a full 47% of respondents said they would not be willing to purchase an annuity product, regardless of price. On the topic of compulsory annuities – discussed by Eureka writer Bruce Brammall in recent ‘Save Our Super’ articles – two thirds of those surveyed indicated they wouldn’t be comfortable with being forced into the product, even if they received value for the investment. Almost 80% did not believe annuities would help them achieve retirement goals.

But perhaps the most surprising element of the research came from a question asking SMSF trustees how much money they would accept if they had the choice of taking $50,000 now or an amount every year for the rest of their lives. The survey found that respondents not only rejected options providing fair value, but that 60% of respondents would not accept an annuity worth double fair value.

The reasons for this are varied, but numerous.

“It highlights that people totally underestimate their longevity,” Rice Warner chief executive Michael Rice said. “Most people were simply not interested in lifetime annuities, probably because they perceive them to be poor value in the current market.”

In a Eureka Report article earlier this year, Lachlan Partners adviser Prabath Ekanayake listed the key downsides investors face. These include no capital left upon death to the estate, no participation in market upside, lack of control, and the additional counterparty risk – the financial health of the institution the annuity is held with.

On longevity risk, or the fear of dying ‘too soon’ and missing out on the full value of the annuity, Rice said deferred annuities were unlikely to be the solution.

“I would say if people find lifetime annuities unattractive, they would find deferred annuities the same,” he said.

“It’s a question of not understanding the value – and the value is probably not great in the market. Interest rates are very low so the annual income looks low at the moment.”

Rice also pointed to the voluntary nature of the system, and the wealth required to purchase one.

“I suspect in a voluntary system not many people would buy them. These are people [SMSF trustees] with quite a lot of money, so they’ve got other options.”

Vanguard principal Robin Bowerman said their research in the US found exactly the same perceptions and problems with take-up there.

And yet, in spite of this relatively small uptake and string of concerns about the product, the main provider of annuities in Australia – Challenger (CGF) – is bullish about the future of the industry and brokers are backing it.

UBS and Deutsche Bank each have ‘buy’ calls on the stock, with UBS saying the company has put to rest any residual internal and regulatory uncertainty surrounding its capital position following the $50 million share buyback announced this week. According to FNArena, broker consensus estimates are for a dividend yield of 5.7% on a PE ratio of 5.6.

Challenger, which reportedly has about 80% of annuity sales in Australia and half of the funds in the annuities market here, held its AGM on Monday in addition to the on-market buyback set for the next six months.

Guidance was affirmed for earnings of $440-450 million, and 15% annuities sales growth.

New chief executive Brian Benari told shareholders that while annuities were still a small part of the market, they were growing at a rapid rate.

“Investors’ horizon for concern has moved out from the short-term to the medium-term,” Benari said.

“That is, from where they would generate retirement income in the next 2-4 years to the next 5-10 years and beyond. This bodes well for longer-term retirement income products like annuities and helps explain why the average tenor of Challenger’s new business has increased progressively from around four years to six years.”

“People in their late 50s and 60s are seeing their parents living well into their 80s and 90s and are beginning to question the quality of life that they might be facing in a retirement that could run for up to a third of their lifetime,” Benari said.

This view to the future is exactly what Keating raised in his address today, and exactly what the Rice Warner survey of SMSF trustees identifies as a major hole in the retirement mentality of Australians. It may not be able to go unaddressed much longer.