The Problem with Mandatory Annuities

A confidential Treasury paper has resurrected the debate around compulsory annuities. Here is why that might be a bad idea.

On 19 March 2014, the British Chancellor of the Exchequer, George Osborne, delivered a budget speech that took the United Kingdom’s pension industry by complete surprise. 

Later referred to as the “bolt from the blue”, Osborne’s speech included the announcement that taxation rules on accessing defined contribution pension accounts would become far more lenient, and, in a definitive death knell to the industry, he added that “no-one will have to buy an annuity”. 

And with that, the UK’s mandatory annuity system was abolished.

A study from the University of Bath found that by 2015 the value of quarterly annuity sales had fallen by 75 per cent from its peak two years earlier.

The exodus happened for several reasons.

Interest rates were at a historic low. In 2014, UK interest rates stood at 0.5 per cent and had been on hold since 2009, a hangover from the global financial crisis. At this rate, most annuity products, which are typically backed by government bonds and, therefore, tied to interest rates, produce almost no income stream. There is literally no reason to buy one at such low rates.

But annuities have a more structural issue: they are complex. Too complex, for most people to feel comfortable with.

Anthony Zeitoun was a retirement income product manager for most of his professional career, and in his last superannuation role he worked for industry super fund Rest. He was involved in various annuity products between 1998 and 2022, when he left the industry. 

During that time, he has saw the launch of at least three annuity products in Australia. Some of these products were innovative and well designed, but none of them managed to get any real traction, he says.

“One product had an entire floor within the bank dedicated to this product, including a number of very smart actuaries. They got to $100 million [in client money], which was less than was spent on developing it,” Zeitoun remembers.

Another product by a well-known financial institution ended up with no more than 15 clients, some of which were family members of the business development managers for the product, he recalls.

Complexity is a fundamental problem in annuities. Most products are sold through financial planners, who often can’t clearly explain the products to their clients, even if they understand the methodology behind the income calculations. 

And these calculations are complex. Annuity payouts are based on a number of assumptions, including average life expectancy, interest rate movements, capital requirements and fund size. Some of these assumptions will change over time.

For example, Zeitoun observed that the type of people who went into these products were healthier and lived longer than the average person, increasing the cost of the annuity to the provider. 

Predicting markets and interest rate movements is also fraught with danger, as is any assumption about the future.

Besides, many financial planners saw it as their job to come up with a foolproof strategy for retirement and were reluctant to recommend simply putting money into an annuity. 

Members also have a variety of reasons to be wary of annuities, beyond the complexity of the product. They wonder whether the company offering the products will still be there when they need the income stream, in the case of a deferred annuity. 

They are also often hesitant to give up part of their account balance for a guarantee, and would rather have the option to leave an inheritance. 

Annuities can also be expensive, depending on how they are used. Historically, most annuities sold in Australia have been short term annuities with a fixed term of between one and five years. 

You can question if people really need a complex actuarial product over such a short time span or whether they are better off with something like a term deposit. Most banks offer term deposits for periods of up to five years and at least you get your money back at the end of it. 

Annuities in the Australian Context

Last week, Treasury distributed a confidential paper in which it launched the idea that Australian super funds should include longevity protection as part of retirement income plans for members with average balances over $200,000 and develop drawdown pathways to help maximise their account balance in the pension phase.

This could include a regular income for a fixed term or for the rest of their life, while the document also refers to the possibility of a pooled fund.

It sounds a lot like an annuity.

Apart from the above mentioned challenges, introducing a measure like compulsory annuities poses a number of questions when placed in the Australian context. For example, what about the Choice legislation? Yes, Choice applies to accumulation, not to retirement, but surely mandating a single retirement strategy is not in the spirit of the existing legislation.

What about voluntary contributions? Will they drop off a cliff if people don’t have access to their account balance over $200,000 anymore, or will super funds be able to demonstrate clearly how additional contributions will lift the level of income in retirement?

What about high account balances? There are many self-managed super funds with tens of millions of dollars in them. Requiring them to purchase an annuity seems somewhat superfluous.

Drawing on his experience with annuities since 1998, Zeitoun acknowledges compulsion is most likely the only way you can make an annuity product work, as history has shown there is simply too little appetite for such products. 

But that doesn’t mean he actually supports mandatory annuities.

“If you look at what the purpose of superannuation is – which is the provision of a pension, not to use your balance to buy a new car in retirement – then some form of annuitisation makes sense,” he says. 

“But this doesn’t have to be an annuity,” he says. “A super fund can play around with an account-based pension to provide an income stream.”

Zeitoun thinks super funds could provide other forms of income streams that are backed by investments, rather than capital, and leverage off the existing expertise within super funds. But he thinks this should be an option as part of an existing repertoire of investment choices, rather than a compulsory product.

“I don’t think anything mandatory is the way to go.”

History seems to agree with Zeitoun. 

After the abolition of compulsory annuities in the UK, the industry shrank dramatically. But annuities never went away completely. 

Annuities have their time and place in retirement strategies, depending on a member’s circumstances, and as interest rates have risen again in recent years the case for annuities has become more palatable again.

In fact, in 2024 the sales of individual annuities in the UK had their best year since their abolition a decade earlier. 

Annuities can be part of a sensible retirement plan, but they don’t work all the time and are not for everyone. 

Providing incentives and an accommodative regulatory environment for annuities seems, therefore, more appropriate than the blunt tool of compulsion.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.