Awareness is building in relation to the benefits and importance of lifetime income products (annuities) in Australia to address the needs of some retirees. In 2014 the Financial System Inquiry noted that “Managing longevity risk through effective pooling … could significantly increase private incomes for many Australians in retirement and provide retirees with the peace of mind that their income will endure throughout retirement, while still allowing them to retain some flexibility to meet unexpected expenses.”[1] This finding has been echoed repeatedly in other government reviews and consultations.
As a result, SIS Reg 1.06A was added in 2017 to encourage product innovation. In 2019 Age Pension incentives were put in place to encourage the uptake of lifetime income products and we’ve seen an expanding number of new products emerging.
In the Retirement Incomes Review final report, the panel assumed retirees will allocate some of their superannuation to longevity products. We then saw the introduction of the Retirement Income Covenant which made it clear that super funds must help their members with these topics.
Australia now has 15 organisations that provide a lifetime income option for retirees. ‘Lifetime’ options are designed to pay income for the full lifespan of each individual customer – in contrast to account-based pensions that can run out.
The question about solvency risk of lifetime income product providers is therefore timely given these products run for a lifetime - perhaps 30 to 40 years into the future. A lot can happen to an issuer e.g. life insurer or super fund, in that time.
(Technically, ‘annuities’ can only be provided by life insurers, while ‘pensions’ can only be provided by superannuation funds. They are effectively the same product but provided by different types of providers, and superannuation funds don’t have the capital required to provide guarantees themselves. This article mainly deals with annuities being provided by life insurers.)
Background – Regulation of annuities
All lifetime income providers in Australia are regulated and supervised under the Australian Prudential Regulation Authority (APRA) prudential framework which involves extensive monitoring and reporting. This covers life insurers that offer lifetime annuities and superannuation funds that offer lifetime income products to their members. APRA is a very inquisitive, active and incisive regulator and no life insurer has failed since the Life Insurance Act was established in 1945. In relation to lifetime annuities, no life insurer has defaulted on an annuity payment.
Insurance companies are subject to the Life Insurance Act. Each year, an annual financial condition report and quarterly returns must be produced by the Company’s appointed actuary in addition to audits by independent firms. APRA is tasked with directing the entities which it supervises, including all lifetime income providers, to take actions to ensure they are able to meet their obligations both now and into the future. Providers must hold sufficient capital backing to demonstrate that they could meet a ‘1 in 200 year’ adverse market event. Basically, if we were to experience the worst market conditions that a 200-year time period might be expected to deliver then lifetime income products are expected to be OK.
All life companies hold significantly more than the regulatory minimum capital and usually have the ability to raise more capital. This capital and retained earnings is held separately from the Statutory Funds or Benefit Funds, which themselves will usually contain sufficient reserves to meet those Funds’ obligations over time. This means the assets supporting lifetime income streams are legally independent, quarantined and protected from any adverse trading conditions of the provider. In the event of an adverse event affecting the provider, the Statutory Funds and their reserves remain able to be dealt with separately as required by the Life Insurance Act 1995 and APRA.
Some life insurers also set up reinsurance arrangements where a reinsurer takes on some of the longevity risk too. Reinsurance transfers some (or all) of the mortality risk away from the provider– so less capital is required by that provider. Reinsurers are often global companies that aggregate capital and insurance business on a world-wide basis – so are not subject to just one market or country and thus have a great spread of risks and less volatility of performance than a national insurer. Reinsurers are subject to regulation in their country of origin as well as the countries in which they operate. However, reinsurers are also subject to failure.
When insurers have looked like they may experience difficulty in the past, APRA has worked with them to restore solvency, which can include asking shareholders to inject more capital or asking them to appoint another insurer to take on the business in their Statutory Funds.
Assessing the solvency risk of a particular provider
Things to look at when assessing the solvency risk of a particular lifetime income product provider include:
- Benefit design of the product – in particular what is guaranteed and what risk is passed on to customers or the reinsurer. See the next section.
- Who provides the guarantees.
- With self-insured pools such as a Group Self Annuitisation (GSA) scheme or lifetime products managed by some superannuation funds, there is no guarantor – meaning that any problems directly impact the assets (and thus solvency) supporting the product. If the product experienced problems i.e. lighter mortality experience than forecast, it may result in a reduction in income payments to customers, rather than losing all their money.
- In other cases the provider e.g. a local insurer, may work closely with another insurer or reinsurer which provides the whole or some of the guarantees.
- The ratio of (a) the assets available to (b) the present value of future annuity payments to customers (the 'liabilities').
- If there is a concern, what has APRA said about that product provider?
The calibre of management is crucial, but hard to assess. That’s why APRA visits product providers regularly and asks telling questions. It is also why APRA requires life insurers to hold operational capital separate to the assets of the product — to protect the investors against poor operational management.
What could cause problems for lifetime income products?
The key risks for lifetime income providers are when the cost of providing the promises made to customers are different to the assumptions that were made when customers purchased the products. This can include:
1. Investment returns not being sufficient to support guaranteed income levels.
Some insurers that provide investment guarantees may experience problems with an asset-liability mis-matching risk, which arises where some of the assets held in the Statutory annuity fund mature but get re-invested at a lower rate than initially assumed. Similarly, the terms on which investments are sold are important e.g. have interest rates risen since the investment was purchased resulting in a loss?
The asset-liability mis-matching risk does not apply to investment-linked lifetime annuities as the actual investment performance is passed on to customers (in a similar way to other superannuation products e.g. via unit prices). Pure investment-linked annuities have an exact matching between assets and liabilities when it comes to investment performance – as the retiree bears the investment risk as they do before retirement and after retirement with Account Based Pensions or ABPs or personal investments.
2. Benefits paid to customers being higher than anticipated.
There are several examples where this may occur:
- With inflation linked annuities. If inflation is higher than expected, then this might be a strain on the assets supporting the product unless they correspondingly increase in value.
- If customers live longer than expected. This means the total income payments to customers will be more than anticipated – which puts a strain on the Statutory or other Fund supporting the product.
Note that lifetime income products that pass on good and bad investment performance to the customers do not provide any investment performance guarantees. This further reduces the chance of provider failure.
Life insurers have to allow in advance for future reductions in mortality rates i.e. increases in life expectancy over time. Longevity improvements are a global trend that is expected to continue into the future due to medical developments and lifestyle improvements. Some financial planning software doesn’t allow for this trend. As a result, projections from that software may make it seem cheaper to use an account-based pension than to purchase a lifetime annuity – if the software doesn’t properly account for how long a client’s retirement income needs to last.
If an annuity provider were to make insufficient allowance for improvements in life expectancy, then a future transfer of assets into the Statutory Fund might be required to maintain solvency. Alternatively, annuity providers can reinsure this risk with global reinsurers.
3. Administration costs being higher than expected.
In other countries, even if an annuity provider experiences financial difficulties, customers are more likely to see a reduction in their annuity income rather than losing their money.
Quality of the management
The quality and risk tolerance of the provider’s executive team is also an important factor, as is the ability to raise shareholders’ capital, if ever required.
Investment managers see this as a very important requirement before they invest in an entity. The management team of an annuity provider need to be experts in the type of risks they have undertaken and the products they have issued. Investors can check the academic qualifications and business experience of the management team.
It's also important for insurance companies to have a solid risk culture, including the Chief Risk Officer and the CEO. If difficulties do arise for any reason they should be identified quickly so that the organisation can rapidly design and implement action plans to mitigate them in a timely manner.
Conclusion
Modern retirement income products involve long timeframes – potentially several decades into the future. For retirees who wish to pass some or all of these risks to a third party, like an insurer, the good news is that APRA does an excellent job in regulating those providers which underwrite annuities and were applicable, their reinsurers. APRA has a strong track record in requiring providers to take relevant actions in order to meet their long-term obligations.
[1] Note that pooling is a form of insurance. With a pool, investors pool assets together and agree rules on how those assets get used to fund their collective needs. With insurance, an insurance company manages the assets and the insurer guarantees what benefits will be payable to customers.
David Orford is the Founder and Managing Director of Optimum Pensions. Optimum Pensions was launched in late 2017 with the objective of providing innovative sustainable retirement income solutions. This article is general information and does not consider the circumstances of any investor.