What can Australia learn from the US as the focus in retirement savings moves from lump sums to income streams?
Treasury, in a discussion paper late last year, described the introduction of new retirement solutions as critical to lifting the living standards and choices of Australians while ensuring the superannuation system remains stable into the future.
With the government planning to enshrine in legislation an income goal for super, Treasury wants to hear from the financial services industry and others by 9 June 2017 about what these comprehensive income (or ‘MyRetirement’) products might look like.
In its discussion paper, Treasury suggested that a MyRetirement product ideally should provide a balance of inflation-adjusted income, risk management, and flexibility.
“Studies typically show that individuals want to maximise their retirement income while managing longevity, inflation, and investment risk and ensure they have sufficient access to their capital for lump-sum withdrawals or unexpected expenses,” the paper says. “Individuals are rarely willing to trade off one retirement objective for another.”
Treasury also highlights the importance of communication, allowing consumers to make meaningful comparisons between different products based on outputs (income, risk, and flexibility) rather than inputs (nature of the underlying component products).
Learning from the US
Many of these questions are being grappled with in other developed economies as governments seek to manage ageing populations and increasing pressures on already-strained public finances.
Like Australia, the US has a mature defined contribution framework and, through the contributions of such thinkers as the Nobel laureate Robert Merton, it also has been looking at how to shift the focus of the system from lump sums to retirement income streams.
“The risk and return variables that now drive investment decisions are not being measured in units that correspond to savers’ retirement goals and their likelihood of meeting them,” Merton says. “Thus, it cannot be said that savers’ funds are being well managed.”
Global asset manager Dimensional, where Merton is resident scientist, has been prominent in the US discussion about retirement income goals. During a recent Australian visit, Dimensional’s Senior Researcher, Massi DeSantis, told local fiduciaries that retirement solutions should help workers grow their assets but also plan the consumption that their portfolios will be able to afford in retirement.
Within this framework, Dr DeSantis cited three key elements:
- Risk management that addresses the risks relevant to retirement income
- Asset allocation that balances the trade-off between asset growth and income risk management
- Meaningful communication that enables fund members to monitor performance in income units.
Risk management around longevity and markets
The first consideration regarding risk management is how long the members’ accumulated savings are expected to support their consumption in retirement. That challenge is growing by the year. In Australia, the average life expectancy of a 65-year-old is 86 years, according to the federal government’s Institute of Health and Welfare. By 2054-2055, the number of Australians aged 65 and over is projected to more than double, with one in every 1,000 people to be aged over 100.
De Santis said that, to account for uncertainty about life expectancy, a five-year buffer can be added to the average retirement horizon, resulting in a 25-year expected withdrawal period, assuming people retire at 65.
The next step is to identify the key drivers of income uncertainty over that withdrawal period, defined in terms of market risk (uncertainty of future stock and bond returns), interest rate risk, and inflation risk.
These risks can be reduced by computing the duration of retirement income streams and allocating to a portfolio of inflation-protected securities that are duration-matched to the planned retirement horizon.
“This framework also helps to manage sequencing risk, as the level of retirement income that can be supported by the allocation to risk management assets is not very sensitive to market risk, interest rate risk, or inflation risk,” Dr DeSantis said.
Asset allocation: growth assets versus risk management assets
Having identified an appropriate risk management strategy, the asset allocation question becomes a trade-off between allocating to growth assets versus risk management assets. The higher the allocation to the risk management assets, the lower the expected volatility of retirement income.
Dimensional in the US recently helped S&P Dow Jones Indices develop an indexing approach to managing the uncertainty of retirement income. The S&P Shift to Retirement Income and DEcumulation (STRIDE) index series uses this framework to seek to grow members’ savings while managing retirement income uncertainty.
“This entails a focus on asset growth early in members’ lifecycles with a transition to an income-focused strategy over time,” Dr DeSantis said. “As participants transition into retirement, the majority of their assets are invested in inflation-protected government securities matched to their retirement horizon.”
Because this is a liquid investment strategy, it provides members the flexibility they need should they require periodic withdrawals in retirement.
Meaningful communication
The third element in the suggested framework for a retirement solution is that it should also allow superannuation fund members (and trustees) to monitor progress toward the retirement income goal. This can be achieved through information that translates the purchasing power of members’ account balances in terms of estimated retirement income.
In the US, the STRIDE indices include a monthly cost of retirement income called the Generalised Retirement Income Liability (GRIL) for each retirement cohort, which can be used to translate account balances to estimated retirement income. (GRIL is defined as the present value of $1 of annual inflation-adjusted income over 25 years starting at the target date. The interest rates used to discount these future hypothetical cash flows to the present are derived from the current US TIPS curve.)
If the GRIL rises, generating a given level of income becomes more costly, and the purchasing power of a given level of savings goes down. If the GRIL falls, the desired monthly income becomes less costly and the purchasing power of savings goes up.
Because of the risk management framework underlying the indices, uncertainty about members’ future income is reduced over time so that communication in income units can be more meaningful.
Jim Parker is a Vice-President and Regional Director, Communications for Dimensional. He adapted this article for Australian audiences from ‘Next Generation Retirement Investing’ by Massi DeSantis and published by S&P Dow Jones Indices in its publication ‘Indexology’.