Changed retiree attitudes and environment; the pending influx of accountant trained advisors and the emergence of enhanced computational tools means a fundamental re-evaluation of how one participates in the retirement income planning space is critical. Currently, there is much fear generated about adequate resources and a focus on “when will the private monies run out”. The new approach must show strategies and techniques that allow a high probability that private resources will last the required distance. It will have far more emphasis on risk management and present results in a stochastic manner rather than deterministic average outcomes.
The Major Risk to be Managed
The top five risks a retiree will need to manage are:
- The uncertainty of the planning duration because they don’t know how long they (and, if relevant, a partner) will live. This is the longevity risk.
- Since private retirement income will come from both investment earnings and capital drawdowns, there will be uncertainty about what these returns will be – the market risk. There is an increasing awareness that the order of the returns is important in determining capital usage – the sequence risk.
- Even at modest steady inflation of 2% - 3% p.a. the purchasing power of a dollar will halve in 20 years. The inflationary risk has in some past periods been a lot more than this.
- The government may change the rules about how retirement income is taxed or what Age Pension may be received – the sovereign risk.
- Miscellaneous risks that range from losses caused by fraud, non-compliance, expense levels etc.
Strategies Available
There are a number of techniques which allow the retiree to control these uncertainties far more than they probably realise. Some of these are:
a) Retirement income comes from both private sources and the Age Pension. One never “runs out” of retirement income because this safety net is there. Most retirees will receive at least a part Age Pension at some stage of their retirement. If you live longer than expected you receive more Age Pension than on average you expected at outset. The same with receipts if your investment returns are lower than expected. This is “offsetting” the risk. The relevance of this aspect depends on the level of your assets and desired retirement income.
b) You can set the required income duration conservatively long and the anticipated investment returns modestly. This technique is called “buffering”. The problem is that it leaves assets to your estate that you may prefer to see supporting a better standard of retirement income.
c) Transfer the problem to someone else – fully or in part. This technique is called "exporting” the risk. There are many products to consider from whole of life immediate annuities to inflation linked fixed term annuities and more complex arrangements. The issues can be lack of flexibility, value for money (especially on early death) and control of capital.
d) Rebalancing or setting up a control cycle. This is a massively powerful technique sorely underutilised in a more formal disciplined way. It can be thought of as similar to the steering on a car. Small adjustments are made frequently to the retirement vehicle to keep it on track to complete the retirement journey. The age of death for those who survive to various durations creeps slowly upwards. But life is not forever and – with the magic of compound interest – only modest adjustments are needed to (say) the planned cost of living yearly increases to keep the plan in balance. A more simple way to envisage this (and one I prefer) is to regard it as setting aside a small yearly premium to set up your own deferred annuity. The aim might be, for example, to have 10 years net of Age Pension resources available at age 90. It allows the focus to be on the highest sustainable income at the years when retirees are likely to be alive and active, while prudently providing for retirement income for the smaller group that survives to an advanced age.
e) Trading as Robert Merton expresses it “or more” for greater certainty. If you can meet your desired income with less volatile investments, your security and certainty increases.
f) Cashflow matching and the similar concept of “immunisation”. Here you match the desired retirement income (the liabilities) with matching asset income. It then doesn’t matter how markets vary. A retiree’s needs are income not market values. What is a particular area of research and application at NetActuary is to create partial immunisation with good quality dividends besides the more usual fixed interest.
g) Careful liquidity management to control the sequence risk issue. We find products such as inflation linked fixed term annuities very useful to keep a higher level of growth assets while at the same time creating the ability not to be forced to realise assets at depressed prices.
h) Laddering of fixed interest and fixed term annuity products to reduce down the reinvestment yield risk.
i) Careful asset sector and product selections that has some inflation protection. Inflation is a friend of borrowers and the enemy of retirees.
j) Diversification to reduce investment volatility and fraud risks.
k) Selection of competent advisors, administrators or product suppliers to reduce compliance penalty risks.
l) Utilisation of tax free threshold and Senior Australian Tax Offsets to hold non-superannuation monies to reduce sovereign risk.
m) Watching the emergence of new products such as deeply deferred annuities. Annuities are the opposite of insurance. You get a better the deal the later you buy and the worse your health if “impaired life” annuities are available.
n) Future innovation. A current area of research at NetActuary is to use the intergenerational opposite needs of accumulation/drawdown to create more certain outcomes.
Centrelink Age Pension
Much of the current financial planning for retirement income is for higher net worth individuals. The need is to take these services to the mass market. Indeed, couples and individuals with modest retirement assets probably need risk management help even more than a rich individual. An essential starting point will be to be able to integrate Age Pension entitlements into the retirement plan. Retirees need to be encouraged to have a realistic – not fearful/cynical – view about future changes. “What happens if there is no Age Pension” is not a constructive conversation. Evaluating later eligibility ages lower indexation and some post age 60 investment/benefit taxes would be far more productive. Capital usage, patterns, the step down on first death, grandfathering or deemed income test decisions, refreshing deductibles, sheltering super assets in a younger partner etc. all affects the present value of future Age Pension receipts that can be obtained for a client.
Enhanced Computational Tools
Dealing with risks and in the stochastic world means the computational tools need to be more sophisticated than those generally in use at the moment. One will need to be able to evaluate how the anticipated age at death creeps up for those who survive. If one’s anticipated life expectancy at birth is age 80, for those who survive to age 80 life expectancy is not zero – it has crept up. Rebalancing, especially for a couple, looks more like a “heat map” rather than a path. Money lasts forever if the payment is half the opening balance, but it is not a good plan. Showing how to rebalance for circumstances that emerge would provide far more comfort and security than retirees have at the moment. That should be a measure about how good the retirement plan is – how comfortable and secure the client feels about the future.
Retirement income planning is not about wealth management. It’s about achieving the desired income. So tools to allow the evaluation of optimal defensive assets in a retirement portfolio are needed. This also has to be integrated with liquidity management to enable management of sequence risk.
Pre Retirement Planning
The challenges here are not so much academic or computational, but how to deliver efficiently and engage the audience. Naturally, the closer they get to retirement the more interest there is likely to be. I find that it’s easier to model what is needed by starting on desired retirement income and retirement date rather than working from where they are at the moment. This starkly shows the cost of retiring well ahead of Age Pension age. Once you have that value then one can consider what current balances and contribution levels, tax efficiencies and tidying up assets like holiday homes can accumulate to by retirement.
Post Retirement Planning
It is a concern that the debate is too produce-orientated – especially about annuities. I personally hope there is a future for annuities for at least part of the retirement income needs over and above the age pension entitlements. Without some adjustment for impaired lives and better returns, it is probable that annuities will not appeal to retirees as much as flexible drawdown arrangements. It will be interesting to watch what happens in one of the world’s largest annuity markets – the UK – now that retirees will no longer be forced to purchase an annuity.
In the US (which has no compulsory annuitisation) about 9% ends up in annuities. However, these are typically fixed duration annuities – not guaranteed life.
Alternative products tend to be too complex to have much appeal for purchasers. I personally think the future for retirement planning advice is to be able to run a more sophisticated, efficient version of what the industry fund Equip Super is doing with its three bucket strategy MyPension service. Its tag line is “Equip MYPension – ready to fill your retirement with confidence”.
The NetActuary Team