Super funds are under increasing pressure to offer a longevity insurance solution to members in retirement. The emerging so-called investment-linked lifetime income stream (ILLIS) product does this while allowing a fund to “layer” longevity protection on an existing pool of assets and thus retain the assets under management.

An ILLIS maximises the use of mortality credits, Age Pension uplift and behavioural effects to help members significantly boost income in retirement. The Age Pension uplift arises from relatively favourable treatment of ILLIS under the assets test for retirees who will traverse the so-called taper zone.

Further, the Age Pension uplift can be boosted when a member allocates to an ILLIS during accumulation by effectively arbitraging a quirk in the assets means test where a member’s Age Pension entitlement is based on the amount allocated to the ILLIS accrued at a deemed earnings rate.

The potential for an Age Pension uplift combined with access to mortality credits gives the ILLIS a clear potential income advantage over the standard approach of investing in a balanced fund during accumulation that is entirely rolled over into an account-based pension (ABP) at retirement.

While it all sounds good for members that ILLIS work well for, the potential widespread take-up of the product poses some thorny issues for policymakers.

A research paper published by The Conexus Institute* (with an accompanying non-technical overview version) notes that the favourable treatment of ILLIS under the Age Pension means test may well encourage greater take-up of lifetime income streams by members when they retire. However, it questions whether the best way to incentivise-take-up is through a substantial net Age Pension uplift where ILLIS are being treated quite generously under the existing rules, thus creating an uneven playing field between products.

It also notes issues of equity given that the uplift does not accrue to low-balance members who receive the full Age Pension anyway. And there are clearly budget implications from fostering a product that allows super fund members to receive more Age Pension than they would otherwise.

More income in retirement

In their research paper, Investment-linked lifetime income streams – Exploring the (considerable) benefits for super fund members, The Conexus Institute outlines how a member can expect higher income from allocating to an ILLIS through a combination of access to mortality credits and potential for an Age Pension uplift.

“The main benefit for members is more income in retirement, and our estimates are [an increase] in the order of 20 per cent is not unreasonable by allocating half of your money at retirement into an ILLIS, as against putting 100 per cent into an ABP,” Geoff Warren, research fellow at The Conexus Institute, says.

With regard to mortality credits: “The income boost comes from two sources. First is the mortality credits, or longevity insurance, which deliver additional income mainly later in retirement as those in the product ‘pool’ who die pass over their assets to those who survive. Second, because you know that income support is coming, you can also afford to draw more income earlier in retirement.”

As is typical with any product offering a form of insurance, the “cost” to members is less flexible access to capital.

“Part of the contract is an undertaking to sacrifice some capital when you die to fund those who survive. While there are many nuances, basically it sums up to a lessening in access to capital” Warren says.

Nevertheless, “for many members, allocating a portion of their assets to an ILLIS can deliver a better balance between the level of income, which is expected to be higher; risk to income, which will be more sustainable; and flexible access to funds, which is diminished but can remain quite reasonable through the ABP allocation.”

Age Pension uplift

The Institute’s paper notes that allocating to an ILLIS at retirement can provide an immediate Age Pension uplift as 60 per cent is counted under the assets test, although the uplift then tapers off and may reverse later in retirement under the income test.

The Age Pension uplift can be enhanced by allocating to an ILLIS during accumulation because “the value counted upon transferring into the ILLIS at retirement is based on the initial allocation indexed at the deeming rate (currently set a 2.75 per cent maximum)”.

“The upshot is that higher returns on the underlying investments have no impact on the treatment of an ILLIS but can increase the value counted for an ABP under the assets test. This acts to enhance the relative access to the Age Pension from an ILLIS versus an ABP when investing in higher-returning assets.”

In other words, putting money into an ILLIS during accumulation could help more members qualify for more Age Pension entitlements that would have been the case had they not allocated to an ILLIS and instead simply rolled over into an ABP at retirement.

Currently there are only a few providers with products offering access to an ILLIS during accumulation, including AMP and MLC. Retirement Magazine understands that other providers and a number of super funds themselves have ILLIS products on the drawing board.

If the benefits are significant at an individual member level, it’s clear that the impact on Age Pension eligibility could scale up to a system-wide level with an associated cost to the Budget. The budget cost will take time to build and will depend on the scope of take-up.

Policymakers’ intentions

The Institute recommends that policymakers make their intentions about the policy framework around ILLIS clear to the industry at large.

“The importance of doing so is heightened by the possibility of a significant expansion in ILLIS offerings by super funds,” it says.

“We sense that super funds are looking closely at recent developments in the offering of ILLIS to members, including making them available during accumulation.”

The Institute notes that many funds might follow the lead of the early movers incentivised by a combination of the benefits of ILLIS for members, scope to base ILLIS around existing investment options and retain control over the assets, and the member retention possibilities of offering access during accumulation. The member retention possibilities relate to the incentive for members to stick with the product at retirement to capture the Age Pension uplift.

“In any event, the industry will be building product based on the existing rules and many must hold some concern over the rules being changed at some stage,” it says.

“While we understand that policymakers have provided no indication of doing so in private, a more definitive statement of intentions to the industry at large would be helpful.”

It suggests three key areas policymakers could focus on:

• The current treatment of ILLIS products under the Age Pension means test, given how ILLIS are currently favoured over ABPs;
• Access to ILLIS during accumulation; and
• Whether lifetime income streams and related Age Pension benefits should be transferrable between providers, perhaps supported by standardisation.

* The Conexus Institute is a not-for-profit think-tank philanthropically funded by Conexus Financial, publisher of Retirement Magazine.