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The world’s greatest annuity

The Age Pension has been a staple of retirement income for Australians since the early 1900s. Despite much public debate in recent years around reducing its benefits, and the latest changes introduced in early 2017, the Age Pension remains a relatively attractive, low risk source of cash flow for the majority of Australian retirees. If you consider its true value, you could say it’s the world’s greatest annuity.

And yet, despite its importance, it is often overlooked by investors when they make asset allocation decisions for their retirement portfolios.

If we think of the age pension as a life insurance company-issued annuity, its product features would look something like this:

  • Yearly income of around $34,382 p.a. per couple [1]
  • Indexed twice yearly (to at least CPI, if not wages)
  • Payments guaranteed for life
  • Spouse reversionary
  • Issued by a AAA-rated entity
  • Government guaranteed

How much would the average retiree couple be willing to pay upfront at age 65 for an income stream such as this? $200,000? $400,000? $600,00? The answer is, probably more.

Looking at an estimated net present value (NPV) of the yearly payments of $34,382 for an average male and female at age 65 on a full Age Pension gives you some idea. For a couple, this works out to be around $653,787; for a single female, around $451,375; and for a single male $398,698[2]. (The higher amount for a single female – on average, an additional three years’ worth of payments – is due to women’s longer life expectancy.)

These figures assume the recipients are on the full Age Pension. However, even for retirees eligible for a reduced pension – due to their assessable financial assets under the ‘assets test’ – the value of the Age Pension remains substantial. For an average 65 year old couple with $400,000 in combined financial assets , the Age Pension still has an estimated NPV of around $592,687.

This is a large sum, particularly compared to the average superannuation balance of $430,650 for the same couple at or near retirement age (60-64 years old). For a single male of this age, the average superannuation account balance is $292,500 and for a female it is $138,150.[3]

The average Australian couple at retirement effectively has $430,650 in accumulated super and, based on that super balance, also has $545,398 worth of future age pension payments (in NPV terms). Considered another way, more than 55% of the average retiree couple’s financial wealth is in the form of the Age Pension.

Yet some investors, when determining the most appropriate asset allocation of their retirement portfolios, focus solely on their accumulated superannuation balances, without taking into account the inherent value of the Age Pension.

Yet some investors, when determining the most appropriate asset allocation of their retirement portfolios, focus solely on their accumulated superannuation balances, without taking into account the inherent value of the Age Pension.

They fail to recognise that the Age Pension, which accounts for a significant portion of their total financial wealth (55% in the example used here), is a 100% defensive low risk asset. The implication of this is that the average investor can afford to be more growth asset-oriented with the remaining 45% (accumulated super balance) when constructing their investment portfolio.

Let’s consider what this means for our couple above who has:

  • Accumulated super at retirement: $430,650
  • Estimated NPV of Age Pension: $545,398
  • Total assets effectively worth: $976,048
  • Risk ‘Conservative’ profile of 40/60 (growth/defensive mix)

 

Applying the traditional approach, this couple would invest the $430,650 in super in a 40/60 balanced portfolio. This would include 40% in growth assets like equities and property, and 60% ($258,390) in defensive assets such as annuities and term deposits.

However if we were to include the Age Pension as an asset in this mix, their effective asset allocation would be 82% exposure to defensive assets, and 18% to growth assets. At the overall level the couple may be $218,000 (or 22%) over-exposed to defensive assets like term deposits and annuities. Such a mismatch between their risk profile and investment portfolio could severely compromise their ability to meet their retirement objectives.

Term deposits and annuities

For most retirees receiving a part pension, the inclusion of investments such as term deposits and annuities in their broader portfolio arguably offers similar exposure to the defensiveness offered by their pension, and therefore make less sense from a diversification perspective. Remember that a basic tenet of diversification is that incremental assets included in a portfolio should bring different characteristics and therefore add to the overall diversification benefit of the portfolio.

It can therefore make sense, when considering a retiree’s asset allocation, to include the Age Pension within the asset mix. If we were to do this for the couple in our earlier example, and then invest the accumulated super balance to achieve an overall portfolio mix of 40/60, then 91% of the super portfolio would be invested in growth assets to give an overall 40/60 mix.

It may sound extreme, but the diversification this delivers means such a portfolio is likely to deliver a more optimal outcome over the long term than the alternative, a portfolio over-exposed to defensive assets.

The Age Pension provides an important source of income for many Australian retirees. The average retiree who doesn’t take into account the inherent value of the Age Pension is almost certainly over-exposed to similar assets with a defensive set of characteristics, namely term deposits and annuities.

We believe it makes sense for retirees to take a more holistic approach to their wealth and financial exposures by considering investments that complement the Age Pension, rather than looking at their superannuation portfolios in isolation. For the average retiree this would likely mean considering more exposure to growth assets and less to traditional defensive investments such as term deposits and annuities.

The value of guarantees

While bank-issued term deposits and life company-issued annuities offer guarantees, are they good value?

The implicit price of the guarantee with a term deposit or annuity is estimated to be 200-400 basis points4 per annum, if not higher. This could be 50% or more of the total return earned by those assets before the bank or life company takes its margin for offering the guarantee.

In our view, this is a relatively expensive premium to pay for certainty, particularly when financial assets are generating a relatively low return and when the Age Pension already offers similar exposure.

[1] Source humanservices.gov.au Assumes couple, homeowner on full age pension entitlement

[2] Aberdeen estimates – based on various assumptions, including constant value of assets during retirement

[3] Source: ASFA ‘Super account balances by age and gender’ Dec 2015