How retirees can avoid running out of money and have an income for life.
Currently, most Australians are left to manage their retirement risks independently and to manage the uncertainty of how long their savings need to last. Will it be a long retirement innings living well into the 90s, or a shorter period plagued by ill-health and unforeseen costs? This uncertainty makes accurately determining the pace of retirement spending a challenge to remain confident that savings will last for a lifetime.
A guaranteed retirement income can alleviate some of this risk; however, most superannuation funds currently only offer an account-based pension allowing members to make withdrawals from their super balance to fund their retirement. Take out too much – and it could mean running out of savings too soon!
This needs to change, and the Retirement Income Review Report observed that there has been insufficient attention on assisting retirees to optimise their retirement income and efficiently access their savings. Studies referenced in the Actuaries Institute’s submission to the Retirement Income Review indicated that most pensioners err on the side of caution, spending less than their assets can theoretically sustain.
There has been insufficient attention on assisting retirees to optimise their retirement income and efficiently access their savings.
Retirement Income Review
Self-insuring their longevity risk in this manner with overly cautious spending patterns may mean a poorer retirement outcome and a lower standard of living, for no real reason. It also means significant retirement benefits paid to beneficiaries—that is not what superannuation tax concessions are designed to achieve.
Sharing the risk
Better retirement outcomes can be delivered by sharing risks amongst groups of retirees and helping each other. For example, pooling investments to gain more diversity or pooling longevity risk to deal with the uncertainty each retiree faces about their lifespan. Modelling by the Australian Government Actuary for the Financial System Enquiry Final Report shows that pooling longevity risk can result in a more stable lifetime retirement income that is 15 per cent to 30 per cent higher than merely drawing down from an account-based pension.
When is a pension not a pension?
The account-based pension is perhaps misnamed. Both the investment risk and the longevity risk are placed entirely on the individual, which means it is not a pension in the traditional sense. Rather, it is an investment account that requires a minimum level of annual withdrawals. The minimum level is a percentage of the balance that varies by age and there is no guarantee that the level of income paid will last for any specified length of time, let alone for life.
A pension for life
The Retirement Income Covenant will take effect from 1 July 2022. At its core, the covenant will require trustees to have a retirement income strategy for the retired members of their fund and for members approaching retirement.
The strategy must, amongst other things, outline how the trustee intends to assist its members in maximising their retirement income and managing the risk of outliving their savings. For many funds, this will mean offering better options for their retired members to turn their retirement savings into retirement income that will last for life.
One efficient approach is to insure longevity risk, allowing a pension to be paid for life. The mathematics of insurance is based on pooling risk. It is common practice to insure homes, contents, cars etc., where premiums paid are pooled together and when a claim is made, the pool’s resources are accessed to pay the claimant. So why not use the same approach to insure the uncertainty of longevity risk?
When longevity risk is insured, it means payments for each retiree will last for life. As a result, it provides better security and (depending on how it is set up) can still allow retirees to have investment choice and an opportunity to have exposure to growth assets. Investment in higher-growth assets provides the opportunity to achieve higher returns and can be more likely to produce an income that can keep pace with long term inflation and provide an income for life.
Extending purchasing power
The following charts show the benefits of investing in a pooled investment-linked lifetime pension versus a standard account-based pension product (drawing the minimum age-based percentage).
The charts show the results of 1,000 simulated projections of investment returns (above CPI) over the next 50 years and assume a 66-year-old female in good health with $200,000 in a conservative-balanced superannuation option (50 per cent allocation to growth assets).
Chart 1: Projected income from an account-based pension
There is an estimated 90 per cent chance that her retirement income will be somewhere within the blue shaded area each year of her life, with a 5 per cent chance it will fall below or 5 per cent above the blue shaded area. The dark blue line in the middle of the shaded area shows the median. The dotted line is the probability of being alive at any given age.
Chart 2: Projected income from a pooled longevity product (investment-linked)
We have used the Optimum Pensions’ Real Lifetime Pension as the pooled product for these charts. The rates used assume the same administration and investment management fee assumptions for both charts, with an additional fee of 0.5 per cent per annum of assets for the longevity insurance provided by a global reinsurer.
Pooling investments has been used for a long time by the superannuation industry. Members’ investments are pooled together, and many funds also use pooled investment vehicles to minimise risk by gaining greater diversification and achieving higher returns. Funds also use pooled arrangements for providing insurance benefits for their accumulation members. In retirement, superannuation funds continue to use pooling for investments.
As we edge closer to 1 July 2022, superannuation funds can use pooling to provide longevity protection for retirees. Ensuring retirees will have an income for life and higher returns by delivering investments in growth assets without the fear of the retirees running out of money will satisfy trustee requirements and help redesign retirement to benefit more Australians.