I woke up this morning full of inspiration. Forget mortgages, forget payments, we desperately need a new wave of annuity products. These fall under Life Insurance products, so we may need to widen our description from a Lending FinTech to an Insurance FinTech, if we actively pursue the creation of these products. Numbers below indicative…further modelling in progress!
What are annuity products?
Simply, these offer a fixed payment (which can be inflation indexed…see our next post) until you die or a fixed period expires. As such, they are often used as post-retirement income products. The concept is simple: you want a fixed amount to live off but have no other sources of income. At retirement, you convert your accumulated wealth in your Super into an Annuity. Retirement is then determined by your Super’s size and your planned spending in retirement versus outlook on life expectancy and inflation.
Much of the above is driven by probability and Actuarial analysis. However, to keep things simple, lets assume you want a 30-year annuity paying $449 per month per $100,000. Much of the following is driven by assumptions, available investments, risk and financial models.
- Inflation will be ignored (it can be hedged with correctly priced equity)
- Available fixed rate assets paying 4.8% per annum (net of expected losses and charges). Yes, they exist.
- Protection capital of 10% (credit enhancement and regulatory capital)
- Distribution and other upfront fees of 1.5% of the notional balance
- Market rate fixed AAA RMBS yield of 3.5% (this feeds our fair-pricing of $449 per month per $100,000)
We find the above is possible to structure (woohoo). However, the variable component is the subordinated equity, otherwise known as the first-loss or equity position. Plugging in the above numbers into a residential mortgage backed security model (this isn’t simple), we obtain an equity return of 13.7% per annum.
In other words, this is fairly attractive dividend yield. Compare it to investing in major bank shares as it achieves similar returns for significantly lower risk (leverage of 10x on residential mortgages versus up to 40x for CBA, ANZ, Westpac and NAB). We could leverage up this 2x (20x overall) to get substantially higher returns.
Further, we can compare this model to Challenger Liquid Lifetime annuities. Without details on the actuarial modelling, I will assume the age 65 Nil inflation protection will pay for 30 years (the $4139 for males is $349 per month). This has a yield of 1.58% versus our 3.5% and we haven’t even included mortality rates in our model.
Finally, if we add in mortality, returns are stronger for the equity tranche. Taking 65 year old male but the expected longevity of a female to 87 years (i.e. 22 years), we adjust the above model and pay equity the remaining cashflows after year 22. The equity yield before leverage increases to 15.2%.
Put simply, we can get $100 more per month per $100,000 ($449 vs $349) for retirees PLUS significantly better Sharpe ratio returns for equity investors.
Next: more modelling, including inflation options, mortality curve and delayed drawdowns.