Superannuation and Investments
Portability for Lifetime Income Streams
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With the maturing of the retirement phase of superannuation, including the requirements of the Retirement Income Covenant , the superannuation and financial advice sectors are assimilating Lifetime Income Stream (LIS) Products into their respective offerings, including through pre-packaged and soft-default structures.
The take up of LISs in Australia is, however, still lower than economic models deem optimal. Several reasons have been put forward for this “annuity puzzle”. [1] One of these reasons - and a regular concern quoted by advisers and superannuation practitioners - is the irrevocable nature of buying a LIS. While there may be a cooling off period, beyond that the level of access you have is limited by the legislated capital access schedule.
To address this concern, this article explores the idea of portability of LISs, [2] including how to address practical issues and the potential benefits for Australian retirees.
Advisers and superannuation trustees may be concerned that if they recommend or nudge their clients or members into a particular LIS in good faith, but then for some reason a more suitable LIS becomes available, their previous clients or members will remain stuck in the original LIS product.
This may cause frustration or complaints from clients or members in the old LIS who feel disadvantaged. The irrevocable nature of LISs is hence seen as a reputational or a compliance risk to using them.
Drawing on global experience, particularly the UK, we explore a solution which could enable portability between LIS product providers in Australia.
The objective would be to give advisers and superannuation trustees significantly more confidence to guide their clients or members to use the LIS product category, and at the same time to assist in ensuring the LIS market remains efficient and competitive.
A key design principle with LIS products in payment is the pooling of lifespan uncertainty across members and/or policyholders. Therefore, it’s essential that customers are restricted from withdrawing from an LIS if they find out their health has suffered. If people could leave when their health declines, those left behind would mostly be the longest-living retirees, and the pool of money would no longer balance as designed.
However, this restriction does not necessarily have to apply at the level of individual providers. The protection can be achieved by the LIS sector as a whole by ensuring portability is only permitted between LIS products, and never into a product where lump sums can be taken (such as an account-based pension).
Removing this moral hazard means all LIS providers can be confident that portability wouldn’t cause them to be the one left with only the very longest living retirees – which would put a strain on their finances that was not anticipated when they were initially set up.
We draw on the experience of the UK in calling the amount transferred from the old to the new LIS the “cash-equivalent transfer value” (CETV). [3]
The following key principles would need to apply to all LIS transfers:
The CETV calculated under these principles would then be paid to the new LIS and be used to set up (purchase) the transferring customer’s new income stream in the new LIS, in a similar way to if it came from a new customer.
A key difference is that transferring LIS members come with their own capital access schedule and purchase price settings that must continue to apply, meaning that it may be necessary for the income from the new product to be calculated on a bespoke basis.
Depending on the products’ rules, the annual level of income they give up in the old LIS may be different to the level of income that gets set up for them in the new LIS. This approach can be applied whether the mortality risk in the old or new LIS is insured or pooled.
While this article focuses on the portability of LISs after income has commenced, an emerging development is new accumulation phase superannuation accounts that also meet certain LIS rules. Because these accounts are designed to transition into a LIS when the member retires, they may begin accruing Age Pension incentives immediately, even before retirement.
During the accumulation phase these products operate just like standard superannuation accounts. They are individual, not pooled, and therefore can be transferred between providers just like regular superannuation. The only legislative change to allow portability of ‘accumulation LIS’ accounts is to ensure the recorded purchase amount (for Centrelink purposes) is also transferred to the receiving LIS provider.
The CETV of current customers should be available online on request. For unbundled LISs , because of the potential of a change in best estimate mortality assumptions for in-force customers compared to when they purchased the product, the CETV may not match the account-balance. This will also be the case where there is a spouse who has passed away; the CETV from the unbundled LIS would reflect the fact it’s now effectively a single-life LIS. Communication around CETV interpretation and calculation will need to be carefully considered.
Under certain circumstances (e.g. bottom-quartile investment performance for an investment-linked product over time), LIS providers could lose large numbers of customers and, as a result, be left with high fixed costs relative to the amount of remaining reserves.
However, this is a problem that applies to all financial products and APRA already has ways of managing these issues (e.g encouraging providers who are sub-scale to merge with other providers). This regulatory oversight could also apply to LIS products in the interests of consumers.
Ideally, exit fees should be small or non-existent. However, for some products the CETV may be invested in such a way that a transfer without an exit fee is impossible (e.g. in illiquid assets or with some smoothing of returns).
If this is disclosed at purchase and cannot be amended, there shouldn’t be any concerns with exit fees as the effective reduction in portability may reduce the attractiveness of products with exit fees.
Investment-linked LIS providers typically design their products using an “assumed interest rate” (AIR). This can also be referred to as a “hurdle rate”.
A higher AIR gives a higher starting payment, at the trade-off of (relatively) lower future payment increases. For someone in poor health, choosing a high AIR is a way to extract higher payments from a LIS before death.
Flexibility to switch between LIS products with different AIRs may be attractive to prospective customers, although could be used nefariously by providers looking to attract customers in poor health under portability.
While it may not be necessary to legislate for this risk immediately (as the moral hazard is low), governments should monitor promotions designed to attract in-force retirees who are in poor health from other providers and determine if further action is necessary.
Potential innovations in LIS design should be considered. One example is “underwritten” (or “enhanced”) annuities, where policyholders can receive a higher annual income due to underlying health conditions that impact their life expectancy.
These are not currently available in Australia but are available in the US and UK. Some basic principles could be applied in this case which would preserve portability. For example:
We believe the introduction of portability of LISs has the potential to remove an important barrier when recommending LIS products – thus making them more popular as an instrument to deliver an income in retirement.
We welcome further discussion with our colleagues in industry, government and academia to further refine this proposal.
[1] See for example; Ramsay and Oguledo, 2018, The Annuity Puzzle and an Outline of Its Solution , North American Actuarial Journal, 22(4), 623-645.
[2] This article is a follow up to a recent article titled “Unbundling of Lifetime Income Streams” where the concept of portability/transferability of lifetime income streams (LISs) is introduced. Some of the ideas of that article have been revised to better reflect the practical application of portability.
[3] In the UK, calculation of CETVs may be done either on a (i) best estimate approach of the lump sum cost of providing the lifetime benefit, or (ii) by an approach determined by Trustees that generates a value higher than (i). UK CETVs are restricted to the accumulation phase only. We argue that this may be able to extend to the retirement phase in Australia if transfers are limited to moving to another LIS provider.
[4] In practice it is more complicated than this simple example. Some of the assumptions used in calculating CETVs may not exactly match that used for new customers. An obvious example is the capital access schedule, which will be different for transferring customers than new customers. Other relevant factors are mortality selection effects, exit fees (see below), etc., noting that the key principle remains that no arbitrage opportunities are available. CETV calculation should be done with clear actuarial guidelines – likely to be produced by the Actuaries Institute in conjunction with regulators. The assumptions for CETV calculations may not always be the same as the assumptions used in calculating internal reserves and capital requirements.
[5] Splitting a LIS between already-existing beneficiaries may not be a selection risk and hence could potentially be permitted. This can be achieved by equitably splitting the CETV between the beneficiaries, which can then be kept in the old LIS or transferred to a new LIS. Such an approach may be useful in cases of separation and divorce. Furthermore, this approach could be appropriate where one beneficiary has died and the other beneficiary wishes to transfer. In this case, the CETV could be equitably split between the beneficiaries (assuming both are alive), with the CETV of the deceased beneficiary forfeited and the CETV of the alive beneficiary available for transfer.
