Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 120

How VicSuper evolved its retirement income model

The recent release of VicSuper’s new non-account based pension (NABP) products for retirees signalled the first of a number of innovative solutions in the retirement income space. More importantly, we have evolved the philosophy and process we follow to help members achieve income security in retirement.

Our previous retirement planning approach

Until recently, VicSuper financial planners used a managed payout approach. In the main, they would recommend a strategy incorporating our account based pension (ABP) with an investment portfolio mix based on the member’s risk profile. The higher the member’s capacity for risk, the more aggressive the investment portfolio and a higher total return would be assumed. We would factor in other forms of income available to the member including the age pension, defined benefit pension and investment income, in preparing our advice. We were aiming to deliver a real level of income that was sustainable, with minimal volatility, which provided members with the flexibility to access capital as needed. Cash flow projections were based on a constant rate of expected return.

There were significant advantages to this approach: the member’s control of investment capital was fully maintained, any returns above expectations could increase the income available, and it was easily implemented by risk profiling a member and investing into the ABP.

The evolution of our methods

However, there were also some weaknesses to this approach:

1. Firstly there was no protection for members against outliving their savings. By basing the analysis on average life expectancies, the approach did not fully address longevity risk by basing the analysis on average life expectancies. This can be relevant to a significant cohort of members (see numbers to the right of the blue line in the diagram below).

.

2. The managed payout approach doesn’t effectively mitigate against sequencing risk where the order and timing of returns could materially impact a member’s income in drawdown phase. Historically, members responded to market volatility by taking less income and the 50% reduction in the minimum drawdown following the GFC allowed for this. However, taking a hypothetical 65-year-old member with $600,000 in their pension account, we felt that an income based on a minimum drawdown that was halved from $30,000 to $15,000 would not be a desirable outcome.

3. Much of the risk in retirement (inflation, longevity and market risk) was also borne by the member. This was traded off against the prospect or possibility of higher returns, however it differed from our approach in accumulation which is to provide default life and income protection insurance to members, and specific needs-based tailored insurance if the member saw a VicSuper financial planner..

4. Lastly, there was no direct asset-liability matching for the member in retirement. So if the member had a need for essential income, with anything below that being unacceptable, our approach in pension phase did not directly manage it. We actively manage this risk in accumulation by providing advice to the member (where appropriate) to use income protection and death and disability insurance to provide needs-based protection.

The probability of outliving savings is real

The ABP minimum drawdown requirements for a 65-year-old starts at a higher point (5%) than much of the recent research on safe withdrawal rates suggests is appropriate to provide a sustainable, indexed income stream with a minimal chance of failure.

This research based on Australian data suggests there is an almost even chance that a typical conservative 25% growth/75% defensive portfolio would be exhausted over a retirement period of 20 years assuming a 6% pa drawdown rate, adjusted for inflation (see table below).

As part of a retirement strategy review we looked carefully at the approach outlined above to determine if there was a better way of achieving our members’ goals.

Our new approach – income layering

Recent research from Investment Trends supports the idea that guarantees and protection (associated with income that lasts for life, guaranteed minimum income payments, protection against market falls and indexed against inflation) become stronger drivers than high returns when retirees are considering retirement income products.

We began looking at different ways we could help our members achieve their goals and meet our best interest duty. One way to deliver this was to develop an objectives-based approach that used an asset-liability matching framework to generate retirement income. Since a member having insufficient income to meet their essential expenses was an outcome to be avoided at all costs, it was perhaps better to not target a strategy that will perform best if we guessed correctly about future market returns, so we took a member’s worst case scenario off the table. One way of doing this was by implementing an income-layering strategy, defined as:

Income layering is a strategy that locks in a secure stream of retirement income before investing any remaining retirement savings in market-based products. It is based on the belief that securing income to meet the essential or basic needs should be of primary importance to the member.

Income-layering starts with detailed budgeting (as much as possible) for the amount of income a member requires each year in retirement, and splitting up this income into essential income and income that can be considered discretionary. ‘Essential’ income should cover the must-have basic expenses like food, clothing and shelter and also those items that define a member’s lifestyle. That is, those things that are non-negotiable because they represent the essence of the member’s life. The discretionary income covers lifestyle requirements that members would be willing to do without if their retirement savings take a turn for the worst.

We’ve now implemented a new advice process that takes into account a member’s health, expected longevity, liquidity needs and balances security with flexibility via internal business rules which guide an appropriate allocation between our various product solutions.

The income-layering approach has protection against longevity risk, and offers upside potential to improve a member’s standard of living. As a priority, essential income is then secured over an appropriate timeframe by a combination of the age pension, any defined benefit pension entitlements, and our VicSuper NABP products. Of critical importance, however, is that the floor income provides as much protection as possible against inflation, longevity and market risk.

Other superannuation money can be invested in the ABP, in a portfolio that aligns with a member’s risk profile. The capital allocated to meeting these two priorities is balanced against other factors, for example if a member has a particular liquidity need requiring significant capital to be available at short notice.

There’s no single silver bullet solution

Whilst investing a member’s entire super into an ABP may (or may not) result in a superior outcome, this depends on investment returns and the sequencing of those returns. The income-layering approach recognises that there is no one ‘silver bullet’ solution in that it uses both guaranteed income streams and an ABP to deliver an appropriate outcome for the member. It provides the member with peace of mind, flexibility, and the opportunity of a growing income in retirement if investment returns are good.

 

Michael Dundon is the Chief Executive Officer of VicSuper.

 

6 Comments
Alun Stevens
August 07, 2015

Optimal management of retirement incomes will also require some form of mortality/longevity risk sharing. If retirees insist on hanging onto every cent of their money, they will 'enjoy' a lower lifestyle than if they put some at risk. No one knows whether they are going to be on the left or right side of the blue line in the graph above. Annuities do help with this, but it is a question as to when to buy them and for what proportion of one's portfolio.

Investment strategies that are heavily skewed to low yielding, but capital value stable investments have little chance of maintaining sensible incomes to advanced ages. Retirees on starting retirement have very long investment horizons - 20+ years. These cannot be matched by short term assets.

The running out of money example is based on a highly conservative asset mix in retirement. My modelling gets much lower probabilities of running out of money, but only with much higher allocations to growth. The catch is how to manage stable(ish) incomes against the background of volatile capital values.

Inflation protection from annuities simply comes from reducing the initial payment and then indexing that. Most current annuity products with high capital returns on death or withdrawal for many years after purchase don't really produce meaningful mortality profits until after these periods pass. Lower mortality profits lead to lower returns. The problem is that people won't buy them without these guarantees so this isn't the fault of the providers.

Income layering is a good concept provided it is matching assets to liabilities by timing and type.

Tortoise
August 01, 2015

So the light bulb just got switched on!

Liam
August 02, 2015

The light bulb is on but it is dimmed to a soft glow? Income layering is what a lot of SMSF Trustees thought they were doing with a range of term deposits from 6 months to 5 years. Alas the sustained low interest environment has exposed the flaw in that strategy. As a previous commentator mentioned, a suitable base level of guaranteed or sustainable income is harder to achieve in low interest rate environments.

Graeme
July 31, 2015

Unfortunately other than the government pension or those in a defined benefit scheme, secure income streams typically rely either directly or indirectly to a large degree on low risk fixed interest backing. Layering therefore works best when rates are high. The amount required to purchase the secure income stream is less, hence there is plenty of capital left over to invest in the market based products. With the current low interest rate situation, many will not be able to fund the income stream. Hence the scramble for riskier market based products like bank shares paying a higher income.

Sure, if you've got heaps of capital, layering works fine. But in that situation so do most traditional financial plans.

Lance
August 04, 2015

Sure layering works best when rates are high. Investing works best when returns are high too!

Not sure your assertion is accurate. Secure income streams are typically backed by various investments, inter alia, long and short duration fixed income, property and equities.

I've checked and these secure income streams typically pay rates of at least 100bps over TD rates. So with the Age Pension providing the base layer (80% of Australian retirees rely on the Age Pension to some degree), the amount required to purchase an additional layer of secure income to meet basic needs is not as great as you would think.

Remember, layering is about ensuring that the retiree has enough to make sure that their basic needs are met for the rest of their lives. It's not about trying to shoot the lights out with every cent you have.

This is particularly important given increasing life expectancies and the attendant high risk of portfolio failure (this article demonstrated a 50% chance of running out of money and having to fall back on the Age Pension).

David Williams
July 31, 2015

Thanks for this succinct analysis. An income layering approach becomes vital when resources are limited and income from personal exertion ceases. It is important that the decisions underlying income layering are reviewed regularly. There are several reasons:
1. The ‘basic needs’ income for many people is still dependent on age pension entitlement. It’s clear that anyone on a part pension is likely to see this diminish over time as the harsh realities of government funding continue to sink in (witness the recent asset test changes and the already inadequate indexing of the entitlement age).
2. The longevity risk increases with age – the longer you live the longer you’re likely to live. It’s also likely that lifespans of older people will continue to increase, reflecting medical and social research.
3. Aged care costs will increase and the importance of having a home to underpin the cost of transition to aged care dependency should not be underestimated. Pledging it early via reverse mortgage to underpin present income can undermine available capital when needed most. Committing the family home without close consultation with potential family carers may also create a harsh backlash down the track.
4. The ‘guaranteed’ income from a lifetime annuity can be compromised if not fully indexed for inflation, or expensive (reflecting the cost of life company guarantees).

Improved personal longevity awareness will increasingly underpin informed decisions and the need for regular review to adapt the layering strategy to each person’s changing circumstances. Over time, longevity awareness increasingly becomes even more important than financial literacy.

 

Leave a Comment:


RELATED ARTICLES

How long will you live?

The big questions facing retirees

When will I retire? Economic impact of an ageing population

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Investment strategies

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Economy

US election implications for investors and Australia

The return of Donald Trump to the US presidency brings the prospect of more US tax cuts and deregulation, but also more tariff hikes, trade wars and policy uncertainty. Here's what it means for markets going forward.

Retirement

The rising tension between housing debt and retirement balances

Australians are taking more mortgage debt into their 60s than ever before. Retirement planning assumptions haven’t adapted and could result in future income projections that ultimately disappoint retirees.

Investment strategies

Why megatrends can deliver big upside (and downside)

The magnitude and duration of society's most important trends are often underestimated. While these trends are usually touted as a tailwind, one in particular could have dark consequences for many assets.

Property

Fixing the construction industry house of cards

Australia needs to build new homes like never before but construction firms keep going belly up. Unless regulators act now, consumers will continue to carry the can.

Investment strategies

How investor portfolios have become riskier versus history

Risk in portfolios has dramatically increased as time horizons have shortened and investors have piled into equities. It's resulted in a growing disconnect between what investors need and what the financial industry is delivering.

Shares

The abacus, big data and a brief history of indexing

Equity indices have evolved over time, led by step-changes in our ability to manipulate data. Despite the rise of passive investing, they weren't initially meant to be investment tools.

Sponsors

Alliances

© 2024 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.