Many people ask me what I think about Stronger Super and the legislation based on the Cooper Review recommendations. Overall, it looks pretty good, although naturally, various compromises and changes of emphasis and approach have occurred here and there. Of course, we also need to see it work in practice.
The big disappointment, though, is retirement. Here, it seems super funds weren’t ready or the changes looked too dramatic. Whatever the reason, we are left with an unfinished retirement system; just a continuation of the accumulation phase. Like the 401(k) regime in the United States, our defined contribution (DC) system was never designed to provide retirement income, but just a lump sum to retire with.
We now realise there is a lot more work to be done in building a proper retirement system. That said, I do acknowledge Bill Shorten’s efforts in pursuing, through the Superannuation Roundtable, ways that new retirement income products could be brought to market. So, progress is being made.
But, what is wrong with DC retirement savings schemes? Well, think of the age pension. Its cash flows are fortnightly; it is AAA-rated; and it keeps up with price and wage inflation. It is the gold standard of retirement products, but the obvious problem is that it is only a safety net. Nobody aspires to live at the standard of living afforded by the age pension. But, the point is all about the design features.
Can the private sector create products that work like the age pension? The answer is that Australian life insurance companies can deliver private pensions that are effectively (apart from obvious differences) the same as the age pension. Okay, what then? Well these need to be integrated into both the super system and into our consciousness: a partial ‘re-intermediation’ of super, accessing specialist balance sheets to provide the secure income in retirement that a purely DC approach cannot by itself deliver.
Governments and corporations around the world realised some time ago that defined benefit (DB) pensions that involved carrying market, inflation and longevity risk for people in retirement were simply too risky and expensive other than for some specialists.
DC seemed like the perfect solution. Because a DC super scheme does not aim to provide the retiree with a particular level of income in retirement, there is no target from which there can be a shortfall.
DB plans pool the risk related to an unknown length of life for each person across the pool, while DC plans leave it to the participants to deal with on their own. This makes most DC retirees like small insurance companies taking on their own longevity risk without any additional capital or the skills to do so. As a person ages, longevity risk overtakes even market risk as the key risk in retirement.
DC also tends to encourage a ‘wealth management’ mindset in retirement, as opposed to a ‘retirement income’ approach. Under the latter approach, retirees get regular income and protection from inflation and longevity risk as a ‘floor’. Only after this floor has been secured and precautionary liquidity is available do they consider exposure to growth assets. There is quite a difference between the two approaches.
Are target date funds the solution? Partly, but it depends on what the retirement solution looks like. Asset allocation alone doesn’t go the distance in protecting against all of the risks in retirement. If a target date fund is merely reducing exposure to volatile asset classes as a person ages, then it is helping with some of the issues – such as sequencing risk and portfolio size effect - but it does not address longevity risk or exposure to inflation.
What is it about retirement that makes a DC fund that is relying solely on asset allocation struggle to provide an adequate solution for retirees? In retirement:
- The ‘financial dynamics’ of accumulation are reversed. There is generally no regular wage or salary (or other income) and the retiree starts drawing down on their savings to fund consumption. This makes it a fundamentally different proposition from accumulating savings and introduces new risks. For example, dollar cost averaging works in reverse, against the retiree’s interests.
- Retirees are exposed to longevity risk: the risk that they outlive their savings by reason of increasing life expectancies.
- The sustainability of retirement savings becomes a new and important concept. This has two elements: the probability of success of the retirement plan (expressed as a percentage of likelihood of reaching a particular age and still being able to access sufficient income) and the range of potential outcomes based on market returns that deviate from long term averages.
- Retirees’ aversion to loss is greatly increased. In a large US study carried out in 2007, just under half the retirees surveyed said they would be unwilling to risk even $10 in a bet that offered a 50% chance of winning $100.
- Close to retirement, more of a retiree’s money is exposed to potential losses and so negative market movements around that time have the most adverse impact on sustainability of cash flows.
- A retiree’s ability to recover from poor investment returns (or take advantage of lower market prices) is generally limited.
- Inflation takes on a new dimension because the retiree is disconnected from wage rises and can generally only maintain purchasing power via the age pension or explicitly inflation-linked investments. Contrary to a widely-held view, equities do not provide an adequate hedge against inflation.
- Plans based on long term averages and notions like ‘investing for the long term’ are generally inappropriate in retirement. This is because approximately half of a typical retiree’s savings are consumed in the first 10 years; later retirement spending is funded from dollars created by compounding returns during retirement.
- The financial needs of retirees differ. The spending profile for someone with $1,000,000 in super won’t be the same as someone who has only $100,000, but it won’t be ten times as much though. A different rate of outflow from the investment portfolio might require a completely different investment mix to get a suitable outcome. The shape of cash flow is important in retirement.
There are no universal solutions to funding a retirement, but it is critical that policy makers address these matters with the increasing number of baby boomers approaching retirement. Over 60% of the value of the superannuation system is owned by the 45-65 year-old cohort.
Part of the solution will lie in thinking about the partial re-intermediation of our DC super system so that retirees get a promise of a certain level of income above the age pension that will last as long as they do.
Jeremy Cooper is Chairman, Retirement Income at Challenger Limited.
Disclosure: Jeremy Cooper is a full-time employee of Challenger Limited and has interests in equity securities issued by Challenger, which is an issuer of annuities in Australia.