Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 167

Deriving an effective retirement income

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.

 

4 Comments
Randall Kingsley
August 05, 2016

Thanks for yet another interesting and thought provoking article. What I think is being missed in almost all of the debate about incomes in retirement, whether the focus is on asset size, incomes to be generated, gradual risk reduction as we age etc is that Retirement itself these days is or is becoming almost as big a period in our lives as 'work' itself.

In my view, the point at retirement is when we have made a decision that our 'wealth' is enough to replace or almost replace our 'work' incomes. So if we are to live as we would wish for around another 30 years (depending on when we take our retirement), most of us have to move from taking a weekly wage income to becoming little capitalists. Our money needs to grow from our capital investments for which we need advice and we need to be drawing an income which is a replacement for our former work incomes for which we also need advice.

So the priority should be both growth and income, considered together to cover a very considerable time. Retirement is a reflection point and not some sort of step change.

Peter Vann
August 04, 2016

Alan

Thanks for the insights from Merton. I find it interesting that quite a few systems in the USA (including to my knowledge Dimensional) forecast a distribution of retirement outcomes by annuitising the balance (itself a statistical distribution) at retirement.

In Australia, I understand that very few people annuitise at retirement. Hence a practical tool would account for the investment characteristics through retirement (as discussed in David Bells' article).

Peter

Peter Vann
August 04, 2016

Ashley
I would welcome your thoughts on what you believe can be used
1) instead of "random, log normal" distributions, and
2) to avoid being (as you say) highly simplistic.
Thanks
Peter

Ashley
August 04, 2016

Theoretical models on retirement built on stochastic (random, log-normal) distributions are highly simplistic. No market over any time frame – from nano-seconds to decades – is or has ever been random or log-normally distributed. Stochastic assumptions understate downside risk by tens of thousands of per cent (yes, I have studied these models).

It's all in the name of wealth transfer which is the free market at work. Nobel himself specifically said economics was not a discipline worthy of recognition. But economists got together and invented their own award 50 years later.

 

Leave a Comment:

RELATED ARTICLES

Superannuation needs greater outcomes focus

How safe is my super from rule changes?

Inflation cruels a comfortable retirement

banner

Most viewed in recent weeks

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are franking credits worth pursuing?

Are franking credits factored into share prices? The data suggests they're probably not, and there are certain types of stocks that offer higher franking credits as well as the prospect for higher returns.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Latest Updates

A nation of landlords and fund managers

Super and housing dwarf every other asset class in Australia, and they’ve both become too big to fail. Can they continue to grow at current rates, and if so, what are the implications for the economy, work and markets?

Economy

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Retirement

Retiring debt-free may not be the best strategy

Retiring with debt may have advantages. Maintaining a mortgage on the family home can provide a line of credit in retirement for flexibility, extra income, and a DIY reverse mortgage strategy.

Shares

Why the ASX is losing Its best companies

The ASX is shrinking not by accident, but by design. A governance model that rewards detachment over ownership is driving capital into private hands and weakening public markets.

Investment strategies

3 reasons the party in big tech stocks may be over

The AI boom has sparked investor euphoria, but under the surface, US big tech is showing cracks - slowing growth, surging capex, and fading dominance signal it's time to question conventional tech optimism.

Investment strategies

Resilience is the new alpha

Trade is now a strategic weapon, reshaping the investment landscape. In this environment, resilient companies - those capable of absorbing shocks and defending margins - are best positioned to outperform.

Shares

The DNA of long-term compounding machines

The next generation of wealth creation is likely to emerge from founder influenced firms that combine scalable models with long-term alignment. Four signs can alert investors to these companies before the crowds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.