Funding retirement: analysing Fixed, Variable and Market-Linked Annuities

Planning for the future and securing a great quality of life post-retirement are common concerns for Australians. As we get older, these concerns become increasingly pressing, and many Australians find themselves struggling to fund their retirement and maintain the quality of life they have grown used to.

Different individuals have different needs, but there is a general rule of thumb for retirement funding — according to the Association of Superannuation Funds of Australia (ASFA) you will need to be able to access around 70% of your annual pre-retirement income during your retirement years. This is enough to ensure a comfortable living standard when you are no longer working.

Unfortunately, the average Australian is currently falling well short of this. On average, retirees are 40% below the benchmark set by the ASFA, translating to a shortfall of around $24,369 per annum. Despite this, the average Australian retiree owns a home worth $1.1 million or 40% above the median price for houses in state and territory capitals across the country. This means retirees are largely wealthy in assets but cannot find the liquid funds they need to support retirement.

Currently, retirees have a limited array of options at their disposal for funding retirement. These are annuities, reverse mortgages, retirement interest-only mortgages, shared application mortgages and guaranteed investment products. Unfortunately, these options may not always be fit for purpose and may not secure a comfortable retirement. In this article, we’re going to be analysing annuities in more detail.

Understanding Annuities

An annuity is an insurance product that provides an income over a series of regular instalments, delivered over a number of years. This may be a specific number of years, or it may simply cover the remainder of the beneficiary’s life. The annuity may be purchased via an insurance company, paid for with capital from a super fund, or accessed via using another form of savings. Typically, the super fund is the better option as this results in tax-free income once the beneficiary is 60 years old.

Importantly, the full premium must be paid upfront when the annuity is purchased. This means annuities are more suitable for cash-rich retirees.

At first glance, an annuity seems like a great option for retirees. However, take-up in Australia remains low for this form of retirement instrument. Why is this? Well, as we have discussed above, many Australians simply do not have the required liquid capital to fund an annuity for the rest of their life following retirement. What’s more, while annuities can offer advantages, there are some downsides to selecting this option, which we will examine below.

Types of Annuities available to retirees

Australian retirees have three types of annuity to choose from: fixed, variable and market-linked. There is a fourth type — the deferred annuity. Whilst deferred annuities are common in UK and USA, they are not offered in Australia as it is more tax-effective to simply make voluntary contributions to your superannuation.

Fixed Annuities

Fixed annuities provide a consistent and predictable level of income for users. The income payments do not increase or decrease and remain the same for the duration of the annuity.

Variable Annuities

Variable annuities are different from fixed annuities in that they do not provide a uniform level of income. The income payments received can increase or decrease according to the performance of the underlying investments.

Market-Linked Annuities 

Market-linked annuities track against a specified market index. This means — just like with variable annuities — the payments received from the annuity are not uniform, but can increase or decrease based on the index’s performance.

The types listed above are simply a general outline of available annuities. Retirees can configure their annuities to provide additional protection — for example, guaranteeing a certain level of income on a variable or market-linked annuity, while still potentially benefitting from positive market movements. While this may seem like a way for retirees to gain the best of both worlds, they will need to pay a fee to secure this. More comprehensive income guarantees carry heavier fees, which can deplete retirement funds.

Potential advantages of Annuities

Annuities can provide advantages to retirees.

  • Capital Can Be Protected

One of the major concerns with any investment- or market-linked vehicle is the risk to capital. With a fixed annuity, this capital is not put at risk, although income levels may be low — particularly in a low interest rate environment. With market-linked and variable annuities, guarantees can protect capital, but this comes with a price.

  • Tax-Free Income When Linked to Super

Income received from the annuity is not subject to tax, provided that two criteria are met — the beneficiary is over 60 years old and the annuity has been purchased with a super fund.

  • Can Be Configured To Provide Funds for the Whole Life

Annuities can be configured to provide regular income for the rest of the beneficiary’s life. In theory, this should deliver peace of mind that everything will be taken care of post-retirement.

Potential disadvantages of Annuities

There are a number of downsides to using annuities to fund retirement.

  • Annuities Are for the Cash-rich Only

Annuities are clearly targeted at cash-rich retirees. Unfortunately, the harsh reality is that the vast majority of retirees are asset-rich and cash-poor, meaning that annuities will never be mass-market products.

The statistics for a couple at retirement age are sobering:

Australia: Average retiree is 42% under-funded and exhausts their retirement savings within 9.7 years

Average retiree wealth is just $150,000 plus superannuation average balances of $270,000 (men) and $157,000 (women) (which together provides $36,628 income per annum)

A comfortable retirement requires $61,000 income per annum (66% of pre-retirement income)

A superannuation balance of $640,000 is required to deliver $61,000 income per annum for 20 years

UK: Average retiree is 80% under-funded and exhausts their savings within 8.5 years

Current media private pension balance is £62,000 (which provides £3,000 income per annum)

A comfortable retirement requires £50,000 income per annum (70% of pre-retirement income)

A private pension balance of £1,125,000 – £1,650,000 is required to deliver £50,000 income per annum for 20 years

USA: Average retiree is 76% under-funded and exhaust their savings within 9.7 years

Average retiree wealth is just $201,000 and median retirement account balance is $120,00 (which provides $12,000 income per annum)

A comfortable requirement requires $50,000 income per annum (70% of pre-retirement income)

A retirement account balance of $1,100,000 is required to deliver $50,000 income per annum for 20 years

  • Annuities Can Reduce Risk But Increase Other Costs

Outsourcing your wealth management in retirement to an insurer is attractive to a risk averse retiree — particularly older women with limited exposure to financial services and investment, who simply want certainty of income in their retirement.

However, this comes at a significant cost to the retiree and loss of control of your capital once the policy’s surrender period has expired.

  • Sequencing Risks Can Result in Shortfalls

If you are using investments to fund your annuity payments in retirement, you are exposed to market forces — you are likely to experience periods of growth and decline over the course of your investment. If the period of decline occurs at the wrong time — i.e. in the years leading up to your retirement — this can have a significant negative impact on retirement funds. This is known as a sequencing risk and can exhaust retirement funds too early.

  • All Types of Annuities Can Be Negatively Affected by Interest Rates

The annuity payments will be determined by the interest rate at the beginning of the term. If this starting interest is low, you will not be able to optimise your retirement funds, even if market interest rates grow.

  • No Flexibility in Payments Received

You have no flexibility or control over your payments. Payments are provided according to the annuity schedule or market performance. If, for example, you need to withdraw a lump sum, this will not be possible with an annuity.

  • Guarantees Can Be Expensive

It is possible to guarantee your income during retirement, even if you choose a market-linked or variable annuity. You can pay extra to achieve these guarantees, ensuring a specified level of income. However, comprehensive guarantees are likely to be expensive, and you’ll still need to pay the guarantee even if the investment or tracked market is growing. Choosing a fixed annuity means you won’t need to pay for a guarantee, but you also won’t be able to leverage market growth.

  • No Way to Leverage Asset Value

As touched on above, the average Australian retiree is experiencing a shortfall in available funds, despite having above-average levels of asset wealth. Annuities do not provide the option to leverage this asset wealth without depleting home equity, resulting in a frustrating situation.

  • Components of Annuity Income May Be Taxable

Any component of annuity income that is derived from investment earnings and not a return of your own capital is taxable.

  • If You Die Early There May Be no Return of Premium

Every annuity has a surrender period and this can be as short as 1, 2 or 3 years. After this point, there are limited or no premium refunds payable in the event of death. Some annuities offer a sliding scale of refunds, so it pays to shop around.

In reality, however, the market has forced insurers to improve these terms and conditions or extend surrender periods. Despite this, insurers are still using their underwriting rules to take a bet on your mortality, and the odds will always be in their favour since they set the rules

Seeking an alternative to Annuity funding

The average retiree needs to be able to access funds from a variety of sources, including available liquid funds as well as those tied up in assets. This is simply not possible with annuity funding, which may render this option unfit for purpose as a retirement vehicle. 

With this in mind, Futureproof is developing the Equity Preservation Mortgage (EPM) as a new, low risk-weighted and responsible alternative. This is an innovative financial instrument that enables users to monetise the capital they have built up in their home into a tax-free equity income, with no depletion of home equity.

The majority of retirees are home owners and, asset-rich and again, the statistics provide some cause for concern:

Australia: Average retiree home wealth is $1,100,000

76% of retirees are home owners

UK: Average retiree home wealth is £500,000

74% of retirees are home owners

USA: Average retiree home wealth is $375,000

80% of retirees are home owners

Why is home wealth so important?

Firstly, housing is the only asset class that is largely unaffected by inflation, low interest rates, volatility in equities and other markets, and global uncertainty. Property quietly appreciates over the long term at the average rate of 4% year-on-year.

Secondly, it is the only asset class of sufficient size and depth to make any real difference to the retirement funding gap. There is simply no other way for a retiree to make up their income shortfall for a comfortable retirement.

The difficulty for banks and insurers is their product gap — they simply have no retirement funding product for the mass-market of asset-rich cash-poor ageing customers.

Up to now, the only significant financial instrument capable of accessing home capital has been the reverse mortgage — another instrument that is not quite fit for purpose as a retirement funding option. Fortunately, this is about to change, for the better.

With the Equity Preservation Mortgage, to be launched in 2023, Futureproof is working to improve lives in retirement.