It is becoming routine to quote Nobel Prize Winner Bill Sharpe in saying that decumulation (determining how much you can regularly and sustainably withdraw from your pension assets) is “the hardest, nastiest problem in finance.”
From a finance perspective, decumulation is so difficult because there are two huge and separate uncertainties involved: how long you will live, and what return you will earn on your retirement assets. Each causes great uncertainty; and yet we have to cope with both. To the mix add the negative psychological effects of all that uncertainty; like confusion, stress and fear of running out of money, and we can easily find the whole prospect too daunting to deal with.
On the positive side, the finance sector has found a reasonable approach to helping people with accumulating retirement assets; that is, setting aside money and deciding how to invest it. It’s a much simpler issue to deal with than decumulation.
There’s still the uncertainty of what exactly investment returns will turn out to be during the accumulation phase. But the time horizon is more forgiving in its impact. Not only do we typically have some ability to control the end date (retirement), but if we postpone it the money tends to continue growing anyway. And we can even keep the investments going after we retire, so all in all, the impact isn’t determined by a single date or event.
Gliding to retirement
One reasonable solution to the decumulation dilemma is to create what has become known as an investment glide path, for which the goal is to give growth-seeking investments time to grow (and time also to overcome temporary setbacks), reducing the growth exposure as we draw nearer to the prospective retirement date (after which there is still usually sufficient time available for the hoped-for recovery if the risk of a sudden investment decline eventuates).
This approach has become so popular that it is frequently offered as the default option with many super accumulation plans, and worldwide roughly 90% of participants go with this default. It saves people who may not feel confident enough (or possess sufficient financial literacy) to make an investment selection from having to do so.
Now compare that with the issues involved in the retirement, or decumulation, phase. While the time horizon for accumulation is known within perhaps a few years, the time horizon for decumulation has a much larger margin of uncertainty – it might be very near or it might be more than 30 years away. This magnifies the effect of investment uncertainty.
Little wonder an unfortunate rule of thumb has developed that the only way to ensure a pension pot doesn’t expire before you do is to never ‘eat capital’ at all – the idealised outcome being to only live on the income produced.
Framing retirement choices appropriately
As with the rest of the world, Australian Baby Boomers started to reach age 65 some 10 years ago and are now retiring in very large numbers. But, by and large, they have no idea what to do with their accrued superannuation benefits. The Australian government is commendably taking a lead on assisting new retirees and is planning to make trustees of super funds offer guidance to retiring members via the Retirement Income Covenant requirement that commences on 1 July 2022.
Problem solved? Not quite! That’s because, as I understand it, the government appears to be emphasizing member choice over default options. Given that default options are not only the norm, but indeed a popular norm, for accumulation, surely the case for default options in decumulation is even more compelling.
I’m not saying that creating default options will be easy – far from it, it will be much more difficult than for accumulation, – but telling members “we’re giving you choices, but beyond that you’re on your own, and we wish you the best of luck” hardly seems constructive.
What sorts of choices would be useful? Well, choices are needed at two levels.
The first and most basic level has nothing to do with the financial technicalities; it simply deals with a member’s attitude. As I expressed the choices in Walk 2 of my Life Two book, this might be:
- Do it for me; in other words, assign a default option to me.
- Do it with me; in other words, help me to combine my own knowledge (of my situation and my goals) with your technical expertise. In turn, this could involve another choice:
- Once you know more about me, assign an option to me.
- Once you explain the options to me, I’ll make the choice myself.
- I’ll do it myself. And in turn that could mean either of these:
- Refer me to a financial planner.
- I’m capable of doing everything on my own.
I understand that in Australia there are also members who are totally disengaged, and do not respond to anything related to their superannuation assets – special provisions will need to apply to them.
Horses for courses
That’s the first level of choices. The second level is the more technical one of actually having explicit default options.
Why do I suggest options (using the plural) rather than a single option? Because it isn’t possible for a single approach to suit everyone – otherwise “the hardest, nastiest problem in finance” would have been solved by now.
What are the complexities that make this so difficult? Partly it’s because, as aforementioned, there are those two separate issues to deal with; uncertain investment returns and uncertain longevity. But there’s another fundamental dimension, and that is to accommodate multiple goals that members probably have.
What’s more, members’ superannuation assets are usually only one part of their total assets. They may have a home, other physical assets, other investments, bank accounts, and so on. It’s a plan for the aggregate assets that’s really needed, and what to do with the super assets needs to fit in with the overall plan. That plan may need to be for the member alone, or for the member and partner as a couple, in which case two sets of assets and joint assets need to be included.
Those multiple goals I referred to could include, for example:
- How do your plans for your own lifestyle interact with your bequest motives?
- How much of your super do you need to finance your own lifestyle?
- Are there certain aspects of your lifestyle that you absolutely want to lock in for as long as you live, with total certainty, to enable you to sleep at night?
There are other relevant questions, as you can imagine, but these are enough to illustrate that there isn’t likely to be a one-size-fits-all solution.
Toward a smoother landing in retirement
To conclude: it’s not enough to identify products and services (and financial planners) and then list them. It is also not enough if these lists are given to members with insufficient explanation and context about how to use them.
It is absolutely essential to ask members about their attitudes, per the first set of bullet points above. And to have a default option specified for each of the various combinations of sets of answers to questions in the (possibly extended) second set of bullets, so that those members who say “Do it for me” can be assigned to the relevant default option. Given the discussion earlier, I’m certain that many retirees will want a default either to be assigned to them or to be guided towards.
I have no doubt that we’ll learn from experience and see which attitudes and sets of circumstances dominate, and which new products and services become available, so that trustees can refine the choices they offer. That’s inevitable, and all to the good. But default options are an essential part of the solution.
Don Ezra, now happily retired, is the former Co-Chairman of global consulting for Russell Investments worldwide, and the author of “Life Two: how to get to and enjoy what used to be called retirement”. This article is general information and does not consider the circumstances of any investor.
[Guest Editor’s Note: It should be noted that under the proposed Retirement Income Covenant requirement that commences on 1 July 2022, super fund trustees will be required to develop retirement income strategies for their members, whether one for all members, or differentiated strategies for different retiree member cohorts.
A recent Treasury consultation paper on the issue suggests that where a cohort approach is adopted, trustees might look to factors such as super balance, expected entitlement to the Age Pension, partner status, home-ownership status and the expected age of drawdown commencement.]