Funding retirement: analysing Guarantee Income Investments
In this 5-part series of articles, we are analysing the advantages and disadvantages of some of the main alternative forms of retirement funding. We have already looked at annuities and shared appreciation mortgages, and now we are taking a closer look at a third type of funding: guaranteed income investment products.
Background
The Association of Superannuation Funds of Australia (ASFA) states that 70% of annual pre-retirement income is enough for Australians to live comfortably once they are no longer working. Currently, the average Australian falls 40% below this benchmark.
This is typically due to a lack of liquid assets. The average Australian retiree owns a home with $1.1 million – a highly valuable asset that is 42% greater than the median value for capital city properties across Australia. In other words, Australian retirees are asset rich and cash poor, which means they must look elsewhere as they secure their retirement funds.
Understanding Guaranteed Investment Products
A guaranteed investment product – or GIP – is essentially a fixed term investment product invested in a lower risk fixed income investment portfolio – this means that equities (listed shares) generally do not form part of the investment mix.
GIPs are a way for retirees to invest their money and secure an income stream without putting that capital at risk. This form of investment provides a regular income to the investor at a pre-determined rate, generally delivered on a monthly basis. These income returns will last for the duration of the investment product term – a time period that is agreed upon before the term begins.
The idea of a guarantee makes this form of investment attractive to individuals, particularly those approaching retirement. Retirees generally want to reduce their exposure to risk, and instead want the peace of mind that comes from a regular return – something that guaranteed investment products can provide.
The Advantages of Guaranteed Investment Products for Retirees
Guaranteed investment products do provide a number of advantages for retirees.
- Age unlimited
A GIP may be purchased by anyone, from 18 up to 80 years of age. This is not the case with most retirement funding products, such as reverse mortgages, shared appreciation mortgages, retirement interest-only mortgages and annuities.
- Returns are guaranteed for the duration of the loan term
The guarantee is the major selling point for this type of investment product. Retirees are able to plan their retirement accordingly, safe in the knowledge that they will receive regular and predictable income for the duration of the pre-agreed term.
- There is no exposure to market forces
The income provided by the guaranteed investment product does not depend on market performance. This makes the product significantly different to other forms of investment, which will only deliver income in the event that the market is performing well.
- Some investment products offer additional flexibility and control for investors
Investors may retain flexibility and control over their capital. For example, guaranteed investment products may be available on either a superannuation or an annotation basis. This means investors can use the fund to either support their retirement years directly or augment their income while they are still working, facilitating better retirement savings. Some providers may also allow investors to withdraw funds before the end of the term, further adding to investor flexibility.
- Reducing risk as part of a retirement funding product mix
The real advantage of a GIP lies in it being part of an overall mix of retirement funding products and strategies. Rather than relying solely on a GIP for retirement funding given the low returns they deliver, it is better retirement solution to use GIPs to reduce sequencing risk in retirement – that is, less direct exposures to financial markets, equities and market-linked investment products. In other words, use the GIP to protect a reasonable portion of your retirement savings against market losses, enjoy the limited income it delivers but use other retirement funding products and strategies to supplement that income.
The better providers of GIPs offer capital loss protections and even the flexibility to increasing the level of protection as you age. In some case, a retiree can select a minimum fixed rate of return with no market risk or a capped higher return with some investment risk. Remember also that any income components derived from market-linked returns are always taxable.
The disadvantages of Guaranteed Investment Products for retirees
Take up of GIPs among retirees remains low, despite the perceived advantages of this kind of instrument. This is because guaranteed investment products are not ideal choices for those looking to supplement their retirement funding, and they may be wholly unsuitable as a primary source of funds. There are several key disadvantages that can make life difficult for retirees who rely on GIPs.
- Short Product Term
Generally, a GIP has a short fixed product term of seven to ten years. In one sense, they are designed to mimic a bond-like instrument. It is not a ‘set and forget’ or lifetime retirement product.
- Reducing risk also reduces reward
Investments have always worked on a risk and reward basis. As a general rule of thumb, the more the individual is willing to risk when they invest, the greater the reward if the investment comes good. While the GIP reduces exposure to risk, as mentioned above, it also reduces the potential exposure to rewards as a result. In a low interest rate environment GIPs are, typically, delivering a very low rate of return – 3% or less. Remember that cash usually deliver a return of 2-2.5% above the official cash rate. This is the risk-free rate of return. So your GIP needs to deliver a return higher than that in order to cover the issuer risk, product cost, market risks and opportunity cost of your capital. If the GIP is unable to exceed a comparable return on cash, then all that it is achieving as a financial product is paying the issuer a fee or profit margin usually in the range of 0.75% to 0.85%. A retiree would, in such circumstances, be better off investing their capital in risk-free assets like a cash savings account, term deposit or government bond.
- Guaranteed investment products are not free
Investors will have to pay a fee to the provider in order to use a guaranteed investment product. This means the already meagre returns that investors receive when they use a GIP are further reduced, as the investor must bear the cost of the product itself.
- Investors are still exposed to other risk factors
The current GIP return of around 2.85% no longer even compensates the rate of inflation. Fluctuations in inflation rates can eat into the income provided by a guaranteed investment product, which can see retirees losing out on funds in real terms. Such products also provide less tax protection than other retirement funding instruments, which can further reduce the benefit the retiree receives.
- Longevity risk is self-insured
Unlike lifetime annuities, GIPs have a fixed agreed product term. This means the retiree is self-insuring longevity risk – that is, the risk they outlive the income stream.
- Guaranteed investment products may not make up for funding shortfall
Once all the above factors are taken into account, one thing becomes clear – a guaranteed investment product may not be enough to make up for the significant funding shortfall experienced by most Australian retirees. As the average shortfall is around 40%, these products simply do not generate enough income to close this gap.
- Withdrawals are costly and limited in amount
In retirement, personal and health circumstances can change, requiring access to your capital via an early withdrawal. Most GIPs severely restrict the ability to withdraw from your account since these are fixed term investment products. The better GIP providers allow a modest withdrawal of up to 5% annually but there is a significant withdrawal fee and, of course, a reduction in your ultimate payout,
Ultimately, there is always a trade-off between product flexibility and certainty of financial outcomes. The lack of flexibility in fixed term investment products reflects the fact that the retiree is outsourcing their wealth management in retirement to an insurer or product issuer.
A better alternative to the Guaranteed Investment Product
Despite the often meagre returns provided by the GIP, the guaranteed aspect of these investment products is still attractive to retirees. The major issue, however, is that a guaranteed investment product is not going to provide anywhere near enough funding to support a comfortable retirement – particularly for those whose funding shortfalls are around or greater than the average of 40%.
In some cases, this “guarantee” might not even be a guarantee at all in real terms. Australian interest rates soared between 2021 and 2022, and – while base interest rate increases from the Reserve Bank of Australia are intended to curb this – inflation is likely to fluctuate significantly in the future. The dollar amount may be guaranteed for the investor, but the purchasing power this amount provides certainly is not.
This is why Futureproof is developing an alternative form of retirement funding – the Equity Preservation Mortgage™ (EPM). This is a new, low-risk-weighted and responsible option that is designed with retirees in mind. Other forms of funding, including guaranteed investment products, are simply not fit for purpose in most cases.
In Australia 76% of retirees are homeowners, compared to the 80% rate of homeownership in the USA and the 74% rate in the United Kingdom. Additionally, the average value of the Australian retiree’s home is $1,100,000, almost double the value of the average American retiree’s home at A$542,000, and significantly better than the UK average value of A$887,000.
With such a high asset value to draw upon, Australian retirees should be able to access a tax-free equity income with no depletion of home equity. Futureproof’s Equity Preservation Mortgage™ provides this.
Reach out to the Futureproof team today and learn more about the advantages of the EPM for Australia’s retirees.
In our next article we will be analysing Retirement Interest Only Mortgages followed by Reverse Mortgages.
Click on the links below to read the first two articles in our series:
Annuities – fixed, variable, market-linked
Retirement Interest-Only Mortgages
Reverse Mortgages
