Superannuation funds are becoming increasingly aware that what members really want is income certainty in their retirement as opposed to just aiming for wealth maximisation and a net worth figure.
The Federal Government wants to enshrine the objective of superannuation in law, as part of its response to the Financial System Inquiry. The Government accepts that the objective is to provide retirement income to substitute or supplement the age pension. That means superannuation fund managers will need to change the way they currently think about risk management and the options they currently offer their members.
Nobel Laureate Robert Merton
American economist Robert Merton, who was in Australia recently to discuss retirement income strategies, is an acknowledged world leader on the subject of retirement incomes. Currently the Resident Scientist at Dimensional Funds Advisers, he is also a Professor at both the MIT Sloan School of Management and Harvard University, and he was awarded the Noble Prize for Economic Sciences in 1997 for developing a method for determining derivatives values.
Merton’s research has more recently focused on lifecycle investing, retirement finance and optimal portfolio selection. In an article written for the Harvard Business Review called ‘The Crisis in Retirement Planning’, he argued that a good retirement investment portfolio had to prioritise income-generating ability over any supposed value. “Asset values and asset volatility are simply the wrong measures to use if you want to derive a sustainable income in your retirement,” Merton said.
Superannuation funds must be mindful when building their portfolios that members will need their money for income regardless of what happens to inflation, stock markets and interest rates, something they may not have prioritised in their investment thinking and planning sufficiently before.
In Australia, the Federal Government has agreed to remove some impediments to retirement income products and for funds to publish income projections on members’ statements. However, these projections can vary wildly and the information has to be meaningful for it to be of much use to investors.
This is where considerations of inflation and interest rates become essential, Merton argues. “Risk-free annuities need to be viewed from an income-generating perspective, and this needs to take inflation into account,” he said. Inflation can have a huge impact on retirement lifestyle. If, for example, inflation is running at 2% per annum over the five years before retirement, the real value of the nest egg in wealth and income terms falls 9%.
Similarly, if a customer puts $300,000 into a term deposit when interest rates were around 7% and five years later, rates have fallen to 2.5%, the interest from that deposit has been cut from $21,000 to $7,500 per annum, a massive 64% decline in income.
Super fund members should be able to see not only what they can potentially afford in retirement but what they can do to manage uncertainty. For example, if they are not on track to achieve their desired level of income, they may have to save more, work longer hours, or simply adjust their expectations if possible.
Communication and risk mitigation
Providing relevant information to investors alongside risk mitigation solutions is a powerful combination. An ideal solution, therefore, allows participants to invest toward retirement income over time while simultaneously protecting investments from market risks.
“Just about everyone who saves or invests does so to support some future consumption. We know that the key to any asset allocation is to identify the right hedging asset for a given liability,” Graham Lennon, Head of Retirement Investment Strategies and Vice President of Dimensional said in a paper called ‘Retirement: Making Income the Outcome’ in November last year.
If a fund member wants to reduce the volatility of their account balance, they can invest in assets that are stable in wealth terms. “How do we manage these risks? We can conceptualise our retirement liability as a series of equal inflation-adjusted payments from retirement to life expectancy,” Lennon said.
This future liability looks a lot like a bond, with a series of payments and a duration. By investing in a portfolio of inflation-protected instruments that match the duration of those payments, it is possible to construct a strategy that hedges interest rate and inflation risk, Lennon argues.
This involves asset allocation that effectively manages the trade-off between assets for income-growth (increasing the balance available to draw income from) and assets for income risk management. Early in the lifecycle of a member’s super fund, their focus should be on income-growth assets. Later, the focus should shift to income risk management, or what Merton describes as “duration-matched inflation-protected securities”. This focus on managing income risk should then continue for the term of the retiree’s natural life.
Alan Hartstein is a freelance writer and editor.