Tax exempt status for deferred annuities bodes well for Challenger

Given that Challenger Ltd (ASX: CFG) has an 80% share of Australia's annuity market, it will be the primary beneficiary of federal government plans, announced on budget night, to extend the tax exempt status of pensions to products such as deferred annuities.

This long awaited reform, that's been a thorn in the side of the financial services industry well before recommendations within David Murray's financial system inquiry to scrap it – which will level the tax playing field – is a milestone in the development of a range of products aimed squarely at the post-retirement market.

As a result of the budget night announcement, earnings on deferred lifetime annuities will be tax exempt from July next year.

This will allow providers like Challenger to offer a much wider range of retirement income products that offer greater flexibility and choice for Australian retirees, and help them to better manage the longevity risk of outliving their savings.

Based on the growing pool of superannuation, together with 700 Baby Boomers heading into retirement every day, plus the growing acceptance of annuities, Challenger's future looks pretty good.

The stock's share price has been on an uptrend – having rallied 25% – since it announced an 80% jump in first half profits to $234 million early February.

In line with the company's guidance, the $5.2 billion financial services group – which controls $57.6 billion of assets under management – reported an underlying net profit to $182 million for the six months ended December 31; while revenue from ordinary activities climbed 12.2% to $950 million from $846.6 million in the year-earlier period, and annuity sales increased 4% to $1.6 billion.

Admittedly, Challenger's high net-debt to equity, currently around 167% has been concerning, but the stock is making efforts to bring it down. On an equally encouraging note, the stock's total funding surplus of $10.169 billion positions it well to capitalise on new and more creative annuity products in response to government's extension of the tax exempt status of pensions to products such as deferred annuities.

Having rallied to an all-time of $9.27, Challenger no longer offers the cheap entry point it did just two months ago, and now trades on a 35% premium to its intrinsic value. However, there's still 15% upside on a higher-end target price of around $10.40.

Challenger's earnings per share (EPS) is forecast to improve from $.055 in 2015 to $0.72 by 2018, while return on equity (ROE) is expected to remain stable at around 13%.

But while Challenger has always been a difficult stock to value, future re-ratings are likely following future disclosure on how it plans to consolidate its dominance within the deferred annuities market once they're tax exempt from July next year.

During its third quarter 2016 update, Challenger reported annuity sales up 29% on the prior corresponding period and strong growth in both term annuities (up 22%) and lifetime annuities (up 63%), with life annuity net book growth for the quarter up 1.6% to $135 million.

It's understood that Challenger has been in consultation with the government on future developments that could see profits from the sale of the family home excluded from the Age Pension assets test – and the purchase of a smaller house exemption from stamp duty – on the pretext that any returns are used to purchase approved lifetime annuity products.

Believers in Challengers' ability to consolidate its dominance in the deferred annuities space, especially after July next year, should look to buy in on dips, with a price closer to $9 making for a more attractive entry point.