An alternate annuity option
For investors looking for higher income from their fixed income investments, particularly those in the retirement phase, annuities may provide the answer. Indexed annuity bonds (IABs) provide an alternate to retail annuities with the potential of offering notably higher returns amongst other benefits. IABs are a ‘direct’ investment as opposed to a ‘managed’ investment by a Life Insurance company and therefore are not subject to management fees.
The five key differences between indexed annuity bonds and retail annuities
- Product design: Both IABs and retail CPI linked annuities have set maturity dates and deliver returns indexed to CPI. Each is an amortising loan with the payments indexed to CPI. The regular interest repayments to investors are adjusted with reference to the inflation rate thus protecting the real value of the investors’ income payments over time. Retail CPI linked annuities can also be issued as ‘whole of life (WOL)’ structures that are not available in IAB’s. However, term defined IAB’s can still be a viable alternative to WOL retail CPI linked annuities when life expectancy is considered. But given this factor, IAB’s may well prove more attractive to those investors comfortable with the set maturity dates.
- Issuers: Only Life Insurance companies can issue retail annuity products, whilst corporate entities account for most IAB issuance.
- Returns: IABs will often provide superior returns to retail annuities as all of your investment is returned to you. Life Insurance companies will extract fees to recoup their costs, extract a margin for profit, and subsequently offer lower returns. In fact, the Life Insurance company may well purchase IAB’s with the investment proceeds received from their retail annuity investors.
- Risk: When purchased singularly, IABs restrict an investor to the risk of a single issuer. However, when a portfolio of IAB’s is purchased, risk is reduced commensurate with the diversity of the corporate names in the portfolio. Therefore IAB’s may be more suited to investors with larger investment proceeds and comfort and understanding of corporate credit worthiness. However, IABs must be considered in light of the investor’s overall portfolio and if adequately diversified across other assets then a single IAB investment may be appropriate. In comparison, retail annuities are more flexible than IABs in that they can be issued in small sizes with specific maturity dates or in WOL format. Additionally, they are exposed to the diversity of the investments held in the APRA regulated Statutory Fund of the Life Company from which the obligation was issued.
- IABs are traded like traditional fixed income securities and while liquidity may be thin, they can be sold if needed without incurring any fees. By comparison, retail annuities can be inflexible in that if you wish to break them and withdraw your money, a fee may be incurred. The significance of this break fee will usually be a function of the remaining term to maturity and the market value change in the underlying assets.
In conclusion, and simply put, the higher returns of IABs equate to the significant benefit of higher cash flow returned to the investor!
For investors who have sufficient capital to build a diversified portfolio of IAB’s, this alternative should be considered.
Example of IAB cashflow
Unlike a traditional fixed income security, where coupons (interest) are the only return to investors over the life of the security until a final ‘bullet’ repayment of capital, principal as well as interest is returned to investors until maturity. Figure 1 illustrates a typical cashflow of an IAB, illustrating the return of capital boosting income to the investor, as well as reducing exposure to the security over time.
Figure 1
Source: FIIG Securities
Who issues IABs?
IABs are most often issued to fund infrastructure projects with definitive time lines and that typically have revenues that are indexed to CPI. For example there are a variety of public-private partnerships (PPPs) which issue these securities, including:
- Praeco (the Department of Defence Headquarters development),
- Southbank (the Southbank Educational Precinct in Brisbane),
- Civic Nexus (Melbourne’s major railway and transport hub Southern Cross Station)
- County Court of Victoria.
All of these PPPs offer IABs in their funding structure with strong CPI linked returns. Such issuers are of investment grade and feature government backed revenue streams (typically CPI linked). Figure 2 gives an example of cash flow and return for some of these issuers based on a notional $100,000 face value investment.
Figure 2
Source: FIIG Securities
Case study: An aged based investment strategy
IABs can be used in conjunction with other inflation liked securities in planning for retirement. A potentially ideal security for an investor moving from accumulation to retirement in the next few years may be a combination of a Capital Indexed Bond (CIB) (while investors are still working and accumulating superannuation funds) then an investment in an IAB in the post retirement phase.
A CIB is a security which offers regular coupon payment however the principle payout at maturity is adjusted for inflation over the life of the bond therefore protecting an investor’s capital.
Therefore an investment in a CIB prior to retirement is a very effective way to build capital and guard against inflation. CIBs have a low coupon (interest) distribution but a high real yield (the yield earned in excess of inflation) with their capital value increasing with inflation. In the post retirement phase, investment in an IAB is an effective way to meet pension and reinvestment requirements given the inflation protected regular repayment of both principal and interest.
By making a few realistic assumptions your FIIG Representative can show how to achieve a desired pension outcome by investing in a CIB and selling it at the point of retirement (or buying a CIB that matures near retirement date) and investing the proceeds into the IAB. We assume you can purchase the IAB at the same real yield as what is available today.
Because the CIB and the IAB prices are both linked to inflation, the CIB has the capacity to provide a (near) perfect hedge for the change in price of the IAB (that is prices of both bonds should move in a similar fashion). This means that whatever changes there are to inflation they will be reflected through the Consumer Price Index. Assuming the companies remain solvent, as the investor, you are protected and will receive that inflation adjusted pension.
Our example shows only two securities for the sake of simplicity. It comprises one CIB and, upon maturity, one IAB.
Example investor and investment requirement
- Investor is currently aged 57 and has an intended retirement age of 65
- Estimates that if they were to retire today they would require an income of $64,000p.a. ($16,000 per quarter) indexed to grow with inflation
- Given a CPI assumption of 2.63% per annum (average CPI since 1992), our investor will need approximately $79,000p.a. income from 2020, if that is when they wish to retire
- Lets round that number up to $80,000 p.a. or $20,000 per quarter, again, indexed to grow with inflation. We will revert to a 2.50% assumption for the rest of the analysis (middle of the RBA target range).
Example investment strategy to meet investment requirement
Question: Given current asset prices, how much capital does this investor need to invest NOW, to achieve the $80,000 cashflow in eight years’ time?
While the answer is dependent on life expectancy, let’s say our investor lives to 80, chosen because the 15 year IAB, that will be invested in, in 8 years’ time, is the longest available IAB currently issued in the Australian market place.
Answer: Given the assumption of CPI at 2.50% (and a few other assumptions) the answer is $566,850.
An investment of $566,850 will buy $460,000 Notional Face Value (FV) Sydney Airport 2020 CIBs, at a real yield of 4.00% (total yield of 6.50% with CPI estimated at 2.50%). This FV is currently index to an adjusted FV of $580,360 which will have a maturing estimated value on 20/11/2020 of $704,000. Additionally, if the coupons that are paid by this bond are reinvested at the assumed reinvestment rate of the current bank bill rate as derived from the interest rate swap curve, they will compound to a value of $199,500 on 20/11/2020.
The subsequent total value of assets held at the completion of the capital accumulation phase, pre the commencement of the pension phase, is $903,500.
This amount will buy $960,660 Notional FV of the JEM Southbank June 2035 IAB at a real yield of 3.80% (total yield of 6.30% with CPI at 2.50%), providing the investor with 15 years of quarterly payments of $20,000 each, indexed to CPI.
Importantly, it does not matter what inflation is, as the investments will appreciate in line with inflation, thus providing the required $64,000 pension (original requirement in today’s terms).
To see the full cashflow of each of the two separate investments, on a date sequenced basis, with proof of the annuity pay down to zero, click here. To see a more detailed explanation, please click here.
Note that the figures in the model were prepared before the coupon payment was due. Also note that these figures do not consider taxation.
Conclusion
For investors interested in annuities, IABs may provide an attractive alternative. They are a ‘direct’ investment, without fees and charges, can offer higher returns and give the flexibility of being able to be sold in unforeseen circumstances. Issuers of such securities are generally of investment grade, have government backed revenue streams and low risk business profiles. For the right investor IABs can offer compelling opportunities.
IABs may also be used as part of a broader retirement plan in combination with other inflation linked bonds. The selection of CIB product pre-retirement provides inflation protected capital accretion. Post retirement an IAB offers an inflation protected amortising cashflow. The attraction of an IAB product is the ability for investors to extract sufficient cashflow to meet their budgetary requirements in pension phase, knowing that the balance of principal invested will always compound higher than the CPI.
For more information please contact the FIIG Intermediary Advisory Team on 1300 752 663.
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