Aaron Minney

‘Do I have enough to retire on?’ is the most common question among people reaching the end of their working lives. But there’s an important nuance to that question that new retirees often don’t ask until it is too late.

‘Will l have enough money available in retirement, when I want to spend it?’

The key risks in retirement are the order and timing of investment returns (sequencing risk), running out of money (longevity risk), volatility in financial markets (market risk) and price rises eating away purchasing power (inflation risk).

They are well understood and many products, including annuities, help solve for these risks. But what about “activity” risk – the fact that people are more active and spend more on holidays and eating out and need more money early in their retirement, compared to later in life.

Traditional annuity products provide secure regular income and help give peace of mind, but are usually only a partial solution. A retiree could live for 30 years, which means they are likely to need exposure to growth assets as well. Few retirees can afford to put their money into cash or government bonds and live off the coupon payments.

Market-linked annuities were developed to solve this challenge. Retirees get life-long, regular income that could contribute to peace of mind, and also get market exposure to help generate income over time.

With a market-linked annuity, retirees’ money generally rises over the long term, potentially providing more income as people get older.

That income pattern is the reverse of what most retirees need. At the age of 90, a person still needs a reasonable amount of income to be comfortable, but not as much as when they are a younger retiree, and much more active.

What an accelerated payment tries to solve is the “activity” risk, changing the timing of the income flows, so a retiree can access more income when they are younger and more active.

In technical terms, it’s an ‘intertemporal transfer’ whereby some of the income is brought forward, better matching spending habits and income of retirees. In return, retirees are giving up some future increase in income.

There’s more money available upfront, and then less over time. A retiree can still receive regular income payments across their retirement although market volatility will still push the income up and down from year-to-year.

The math of the recently launched Accelerated payment option for Challenger’s market-linked annuities demonstrates how it works.

If a 67-year-old male/female couple are prepared to forgo 2 per cent per annum of future indexation, their initial payments are approximately 32 per cent higher than standard payments. If they are prepared to forgo 5 per cent per annum of future indexation their initial payments are about 88 per cent higher.

There is an important caveat to this. Market-linked annuities are, by definition, linked to rises and falls in the market. Income will rise and fall along with the market. It’s self-evident, but also critical for a buyer of market-linked annuities to keep in mind.

When considering an accelerated payment option on an annuity-style product, buyers should also look closely at returns and fees. Although past performance is not an indicator of future performance, long run real returns of anything over five per cent are optimistic. Retirees should only take the large adjustment if they are prepared for their income to fall (in real terms) and go up and down from the start of retirement. And buyers need to know if fees are included as part of the annuity product or are charged independently.

Annuity style products, linked to the market with, or without, accelerated payments, must still fundamentally be a secure investment option with regular payments that is simple enough to be understood by a retiree. With that comes peace of mind and income for life.

By Aaron Minney, Head of Retirement Income Research

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