A Japanese sales bonanza and rapid returns from Challenger's UK pensions business have improved Morningstar's outlook for Australia's largest annuities company.

"This is expected to increase future income by about $20 million from fiscal 2021," says Morningstar equity analyst Chanaka Gunasekera.

In response, he lifted his fair value estimate by 13 per cent to $9.30, from $8.20.

The company reported group assets of $279 million for the half, up 3 per cent or $9 million on the same time a year earlier.

During the half, Challenger (ASX: CGF) benefited from rising institutional demand from Japanese clients seeking guaranteed returns amid low interest rates. It sold almost $1 billion worth of annuities, 169 per cent higher than in the same period a year earlier.

Citizens aged 65 years or older make up 25 per cent of Japan's population, and this figure is tipped to top 30 per cent in the next 30 years.

And in the UK, the payoff from Challenger's purchase of three large pension businesses kicked in sooner than management had hoped. The value of its UK life risk portfolio grew 67 per cent to $830 million during the first half 2020.

Challenger shares were trading at $10.16 at the close on Monday, slightly lower than what Gunasekera thinks they're worth, but in a range Morningstar considers fairly valued.

'Tug of war'

Closer to home, Challenger's dominant Australian annuities business is a growth industry because of the country’s ageing population and well-established system of compulsory superannuation. But it's not all good news on the home front.

Challenger CEO Richard Howes said strong Japanese and Australian institutional sales had offset lower domestic sales, which continue to be affected by disruption in the financial advice market.

Gunasekera describes it as a "tug of war" between short-term and long-term issues affecting Challenger, many of which are outside management's control.

The three key influences on its Australian business are:

  • Low interest rates
  • A flat yield curve, which reduces annuities demand
  • Disruptions at major financial hubs following the banking royal commission.

The longer-term trajectory for annuities demand in Australia is good. Some 92 per cent of group earnings come from annuities – pension products that combine elements of life insurance and investments to provide income for individuals after they retire from full-time work.

"We expect Australia's new retirement legislation … to be a boost for Challenger's annuity business," Gunasekera says.

"Challenger's annuities are well integrated in the wealth management ecosystem, with strong brand awareness, and relationships with financial advisers, dealer groups, platform administrators, and super fund trustees."

But the Hayne royal commission's scrutiny of financial advisers has taken a big bite out of the company's primary distribution channel, as the big banks bail out of wealth management.

This has hurt Challenger's near-term sales of annuities – but not as much as management had feared.

This is partly a result of the firm's program of working more closely with financial advisers to help them better understand how new rules affect Challenger's CarePlus product. These government regulations allow individuals to access higher age pension entitlements earlier.

Challenger invested $15 million to engage with advisers on these changes along with distribution, product design and marketing.

"These investments appear to be bearing fruit, with management reporting a new cohort of advisers that are becoming more familiar with the new rules," Gunasekera says.

This meant the margin squeeze alluded to earlier had a more muted effect, and sales of annuities in Australia ticked up 22 per cent faster in the backend of the half.

The group is poised to benefit from new federal government retirement income legislation requiring more products like Challenger's own annuities. But so are others in the industry.

"We forecast continued pressure on margins due to changes in Challenger's product mix, increasing competition and high asset prices," says Gunasekera.

Howes said Challenger was on track to meet the top end of its guidance for the full year 2020, tipping net profit before tax of between $500 million and $550 million.