Until recently most of the commentary about superannuation and retirement focused around maximizing the amount of wealth at the point of retirement (Terminal Wealth - TW) rather than on the issue of these retirement savings providing a sustainable income during the retired phase (Retirement Income - RI).
Around the world in general and in Australia in particular (as Australia is generally one of the first movers in terms of innovation in the actuarial space), there has been a move away from the defined benefit schemes toward defined contribution schemes. Under defined benefit, generally the fund provided a pension (usually with some level of inflation indexation) at retirement to the retiree which was guaranteed until death. This generally meant that the retiree needed only to focus on ensuring that their expenditure needs would be met by this pension and possibly some level of social security benefits. However, under defined contribution schemes, such pensions are non-existent and the retirees are burdened with the additional concerns about investments returns and longevity. The transference of these risks to the retiree make the whole debate about Terminal Wealth and Retirement Income particularly significant in retirement planning.
(Note, in this blog item, we will assume that individuals only can control their asset allocation. We will consider consumption, and hence contributions to their superannuation accounts in next month’s blog).
So the question is HOW?
Consider an individual aged 25 just entering the workforce. Their superannuation balance is 0. Let us assume they will work till age 65 and retire immediately after that. Also, in our example, assume that they will die at exact age 95.
Under the retirement income objective, the individual’s investment horizon is 70 years, of which they will be working for the first 40 years and contributing to their superannuation account and these funds will fund their lifestyle over the last 30 years. On the other hand, under the terminal wealth objective, the individual’s investment horizon is 40 years, during which they will be working the whole time and contributing to their super account. At retirement, they will then switch to the ‘correct’ retirement income objective to fund their retirement from these funds.
At the beginning of the individual’s working life, their investment horizon is long, so they are fully invested in high risk assets. This particular behaviour stems from the research on lifecycle theories. The theory states that when the ‘bond’ like future income earning potential is high (i.e. human capital), the individuals have more scope to ride out the volatility in high risk investments while maximizing their earning potential. Moreover, the length of investment horizon also is a factor in the level of risk an individual should take.
Under the RI objective, the individual’s investment horizon is much longer than under TW objective. Hence, under the RI objective, the individual is fully invested in risky assets for much longer than under TW. In particular, my research indicates that ceteris paribus an individual is fully invested in risky assets until age 43 under RI and until age 38 under TW.
Under RI, the individual reduces their risky asset allocation steadily to about 28% at age 65. While, under TW, the individual reduces their allocation steadily to 20% by age 60. Between ages 60 and 65 in order to preserve their capital against sudden adverse market movements, dis-invest from risky assets rapidly ending at about 10% at age 65. [There is some movement for the level of superannuation balance, with lower risky asset allocation for higher balances for each age].
Retirement and Post-retirement
Due to the higher level of equity allocation under RI, on average, under the RI scenario the individual’s superannuation balance at retirement is higher, than under the TW scenario. (Obviously, unless an extreme market event, like the GFC, happens in the last five years prior to retirement).
This is an interesting result. We see that the RI objective, which tends to maximize spending in retirement, inadvertently provides higher balances at retirement than the TW objective itself.
Now, after retirement the individual’s human capital is 0 as they have no more future earning potential. Research shows that, under such a scenario the level of risky asset allocation depends on the individual’s level of risk aversion and is independent of the level of superannuation balances. The average allocation is somewhere between 30% and 50% for most of the population. Furthermore, irrespective of the objective initially chosen by the individual, the superannuation savings at retirement still have to fund their retirement.
Given that under the TW scenario, the individual generally ends up with a lower superannuation balance at retirement than under the RI scenario; and that the ‘optimal’ risky asset allocation post-retirement is based on the individual’s risk preferences, choosing an incorrect TW objective compared to the RI objective leads to worse outcomes (lower income in retirement) for the individual.
Hence, getting the investment horizon correct from the very outset is very important from an individual’s perspective, in order to maximize their income in retirement.
Garry Khemka is an Assistant Professor of Actuarial Science at Bond University. His main area of research is optimizing the retirement outcomes for Australians. This blog entry is based on his publication “The effect of objective formulation on retirement decision making”.