How can there be a lifetime guarantee of pension payments?

The lifetime guarantee is not due to the superior investment skills of the product issuer and it is not due to the fact that the issuer of the product will finance the product out of their own pockets.  The financing of the lifetime guarantee can only be from three sources: the product issuer, from investment earnings or from other investors in the product.  

The first source – the product issuer – is possible.  If the product issuer is a “for profit” enterprise, it may place some seed capital into a pool to provide some initial support for the product.  However, in the long run, the product issuer cannot loss lead as this may ultimately result in financial collapse of the issuer.  If the product issuer is a “not for profit” enterprise, it may have retained earnings from its other activities but it cannot indefinitely loss lead as its retained earnings will diminish.  Additionally for both “for profit” and “not for profit”, they cannot cross subsidise between products.  Neither the purchasers of the product supporting the other profit nor the regulator would be too happy about this situation.

The second source – from retaining (or holding back from the investors) some of the investment return generated by the pool of assets which supports these new products  –  is possible.  However, it is only possible if there are positive earnings (either current or from prior years) and it means that the full earnings are not being distributed to the investors whose capital has generated those earnings.  Consequently, the investors in the product will be obtaining a lower return than they would otherwise have obtained.  Essentially, the investors will be allocated lower returns and paying for the lifetime guarantee by lower returns.

The third source – from other investors in the product who exit the product – is not only possible but most likely the principal source of finance for the lifetime guarantee.  This source of finance is possible because there is a transfer of pension capital from those investors who exit early (whether by death or cashing out) to those investors who remain.  This loss of pension capital by the transfer of pension capital on the death or exit of an investor is the essence of the new type of product.  

Because this loss of pension capital is very unappealing – the loss of pension capital will occur over the life expectancy of the investor.  For example, if the life expectancy of the investor is 20 years and the investor cashes out the product after 5 years, then 25% of the initial capital the loss and the maximum amount the investor can be paid will be 75% of their initial investment. If the investor cashes out the product after 18 years, then the maximum amount the investor can be paid out is 10% of their initial investment.  Once the life expectancy period has expired the product will cease to have any cash out value.  It is irrelevant whether the cashing out is to rollover theinvestment to another superannuation entity or to finance the Women’s Weekly World Discovery tour.

The harshness of the loss of pension capital is subject to two exceptions.  The exception is that if the investor decides to exit the product within the first 14 days (ie during the “free look” period) will they will be repaid 100% of their investment.  

The second exception is that if the investor dies within the first half of their life expectancy period, there will be 100% return of their investment.