Why does the finance industry not like lifetime annuities?

Are there any products that someone in the finance industry will not sell to potential customers for a buck? Think: life cover for 15-year-olds, unemployment cover for full time students, buy now pay later for socks. What about underwritten lifetime annuities?

The technology to offer enhanced benefits for those with lower life expectancies has been available for at least 30 years. For those with a life expectancy of, say, 10 years for reasons of age or poor health, the guaranteed inflation-linked income return should be about 10%. Of the over 1.5 million Australians in this position, is there no market worth exploiting?

As a history enthusiast, I cannot avoid pointing out that enough life annuities had been sold in ancient Rome to create an annuitant life table almost two thousand years ago. The fall of the Roman Empire was such a disaster that we still not have enough data to create one in Australia today!

Academics calls the absence of a lifetime annuity market the ‘Annuity Puzzle’. Why do retirees not ensure their longevity risk when there are clear benefits?

Their research has made the assumption that there is almost no demand. If there were a demand, the further assumption would be that the innovative financial industry would find a way to satisfy it.

As actuaries, we should be suspicious of assumptions. What if those in the financial services industry have undermined lifetime annuities because they fear that they will make less money overall if lifetime annuities were popular? They would of course be making less money. Financial advisors would have less reason to continue to give advice to people on what to spend and save. Pension balances and administration fees would be smaller because pensioners would be spending more earlier on in retirement. Investment managers would have to look for long term ‘bottom drawer’ investments that would not justify charging active management fees.

In my paper Supply Side Resistance to Lifetime Annuities and associated concurrent presentation at the 2022 All-Actuaries Summit, I investigated the evidence for both demand and supply side reasons for the absence of an annuity market. I would welcome alternative evidence that proves me wrong – because the consequence of my current arguments is that we have been failing retirees.

We are told by business and academics that there are good reasons why there will be no demand for annuities. Firstly, the Association of Superannuation Funds of Australia (ASFA) questions whether annuities can increase consumption by some 30% for normal retirees – suggesting perhaps that the benefits are immaterial. But this does not apply to those with shorter life expectancies. Then, we are told that people want to leave a bequest. But careful research shows such concerns are more of a justification for holding a contingency fund for unexpected expenses.

The need to cover out-of-pocket medical costs and other large expenses is frequently mentioned, but this is much less relevant to Australia with our public and private health insurance. Contingency funds are important, but industry suggests amounts of at least $200,000, which are eight times the annual Age Pension. A contingency fund needs to absorb unusual costs and then be rebuilt. The evidence is that even those on the Age Pension do rebuild their financial assets, but aim at perhaps twice annual expenditure, which is already high. Linked to this is the idea that the Age Pension crowds out the need for lifetime annuities.

But if you only need about $50,000 as a contingency fund, you need a consumption plan to spend the rest: a life annuity.

The other reasons often repeated show an extraordinary ignorance of potential annuity design: annuities offer poor value for those with lower life expectances and investment returns are unattractive. Enhanced annuities – discussed earlier – make up approximately 30% of the UK market. Actuaries have known how to design investment linked lifetime annuities for 75 years, and can incorporate every possible investment option that is available for account based pensions. It is difficult not to think that there is an element of wilfulness in the ignorance shown by those making these arguments.

The final reason to consider is that potential annuitants are subject to behavioural biases and misunderstandings. What about bias and misunderstanding on the side of the providers?

Perhaps the worst misunderstanding is the widespread use of inappropriate profit metrics by the big banks, which have controlled most of the financial sector over the past few decades. The arithmetic is not difficult. The profit to maximise is the difference between the rate of return on capital (ROC) less the cost of capital times the capital employed. This is sometimes called Economic Value Added (EVA). Rejecting projects where the expected return on capital is greater than your cost of capital is to reduce your profit even if it reduces the average ROC. The cost to income ratio (CIR) does not come into the equation.

In spite of this, Ken Henry told us at the Summit that NAB shareholders told him, as chairman, that they wanted to see an increase in ROC and a reduction in CIR.

Perhaps that is why NAB made these metrics two of their four key objectives – at least until 2018. We really need to educate our investment managers in the basic arithmetic of finance.

The consequences of this misunderstanding can be seen in the closure of rural branches that have sometimes been replaced by community banks; in the failure of the finance industry to establish a significant presence in any Asian country despite our proximity and the success of European, American and even South African firms; in the sale of banks’ life insurance subsidiaries to Japanese, Asian and European firms; and in their failure to develop lifetime annuity products.

To be fair, the regulators have not been helpful. Investment-linked annuities did not qualify for tax advantages before 2017 and thus really did offer poor value. The Australian Taxation Office still seems to think that the ‘mortality credits’ should count as contributions and appears to place unnecessary obstacles in the way of innovative designs. The unspeakably complex product marketing and advice regulations create potential pitfalls. Fund managements have also been inundated by a flood of new regulations and mergers that have been encouraged by the regulators.

The requirements of the Retirement Income Covenant legislation offer an opportunity to revisit the assumptions surrounding the demand and supply of lifetime annuities. As academics, industry participants and regulators, we can perhaps take time for introspection as to whether we can do better at putting members’ interests first.

Three investment-linked products have already been introduced in the past year. Others will hopefully follow. 

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