Can retirement income products make the savings last?

This year has seen the first among Baby Boomers hatch their retirement eggs. But as Freya Purnell reports, the industry is starting to realise that the current retirement incomes product set is not sufficient and needs drastic innovation.

Related: The growth of allocated pensions and annuities

Having spent years, maybe even decades accumulating wealth, when that retirement rolls around, it’s time for the nest egg to hatch.

But to help clients make a successful transition to retirement, a different mindset, different strategies, and different products from those used in accumulation are needed to manage the unique risks.

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In 2012, the first of the 5.5 million-strong Baby Boomer generation started to move into retirement.

As a huge volume of superannuation savings makes the transition with them, the chorus of voices seeking the answers to some crucial questions – ‘will I have enough money to retire on’, and ‘how can I make the funds I have last as long as possible?’ – will become even louder.

Kicking off the conversation

While some clients leave thinking about exactly how they’re going to cover their living expenses in retirement until the eleventh hour, ideally conversations with advisers about retirement strategies and structures start about a decade out from when clients plan to finish full-time work for good.

Investment Trends research shows that typically, advisers begin speaking to clients about their retirement plans on average seven-and-a-half years before retirement.

Damien Jordan CFP [Certified Financial Planner] of Jordan Financial Services says starting this early gives clients the best chance of being able to use the levers they have available to them while they are still working.

“In terms of actually knowing how much you need, how long it’s going to last, and being able to build a really nice estate where it’s a combination of super money and other investments outside of it, you need a window of time to compound and actually plan for lesser markets too, depending on your risk profile as well,” says Jordan.

From a psychological perspective, Greg Cook CFP, managing director, Eureka Financial Group, says often reaching their mid-40s sees clients come to the realisation that they have passed the halfway point in terms of their income-generating capacity.

Factors such as the age of their youngest child, and whether they have paid off their mortgage and now have surplus cashflow, also affect when they will start making retirement savings a priority.

Particularly given the limitations imposed by superannuation contribution caps now, he says, it’s never too early to start.

“You need to contribute on a more progressive basis, rather than saying, ‘Now I’ve got rid of my mortgage, I’m going to spend the next four years really ramping up my super’,” Cook says.

Facing fears

As you might expect, these early discussions start to give an insight into clients’ fears and concerns about their income in retirement. And the answers are not that surprising.

The Investment Trends December 2011 Retirement Income Report, based on a survey of 1,461 Australians aged over 40, asked respondents what concerns they have about their finances.

Fifty-two per cent said they were concerned about not having enough money to retire on, with 47 per cent saying they were concerned about inflation.

Among those aged over 40, only 27 per cent of Australian adults felt they were on track to achieve their retirement goals, down from 36 per cent in 2010, with 38 per cent feeling they were behind.

Scott Mitton, financial adviser, RI Advice Group, sees concerns about flexibility, how long their money will last, market exposure and risk, tax, and the fear of the unknown come up frequently in his discussions with clients.

The global financial crisis has clearly left a legacy for many of those now staring down the barrel of retirement, with many still “panicky about the fact that their funds are exposed to losing large amounts of capital”, says Jordan.

There can also be a lack of understanding of the difference between investment vehicles and asset allocation, and the inherent risks carried by these.

“A common concern we see is people thinking that superannuation equals market volatility, when in reality you can have one account that has a term deposit, and one account that has 100 per cent international shares.

"So that’s probably a re-education process for new clients and particularly for people who have been burnt,” Mitton says.

There are also concerns with their origins in lifestyle choices. Particularly for the Baby Boomers, Cook says clients are often facing a situation where children in their 20s or even early 30s are still semi-dependent – they may have moved back in, had a marriage breakdown, or require more assistance than expected with their own children.

“A lot of the Baby Boomers seem to be compromising their own situation to help out their children,” says Cook.

How much is enough? Calculating retirement needs

Crucial to making retirement plans is the magic number – just how much will be enough to live on in retirement?

The Association of Superannuation Funds of Australia (ASFA) Retirement Standard examines current retiree spending patterns to find benchmark figures for different levels of lifestyle.

The latest figures, for the June 2012 quarter, show that a couple looking to achieve a ‘comfortable’ retirement will need to spend approximately $55,213 a year, while those seeking a ‘modest’ retirement lifestyle will need $31,760 a year.

‘Comfortable’ is, in this case, aspirational, with this standard of living only achieved by about 20-25 per cent of retirees, according to ASFA director of research, Ross Clare.

Another industry rule of thumb says retirees will need about 60 per cent of their pre-retirement income, minus major expenses such as mortgage payments or children’s education expenses, which are expected to have been discharged by the time the client retires.

While these might provide indicative figures, some planners prefer to be more precise – actually completing a retirement budget with clients to fully understand their individual cashflow requirements, and importantly, the pattern of these needs, which can be crucial when selecting retirement strategies and products.

These calculations help clients to estimate their income needs per year, but to get the big picture, there are two complicating factors: retirees’ spending patterns change over time, and no-one knows how many years after retirement they will live.

Clare says as retirees age, their expenditures change – while at age 70, retirees may still be spending on running a car and overseas travel, by age 90, many of these expenses will have dropped away, in favour of greater assistance with housekeeping, and home-based or health care.

"The software doesn’t usually take that into account. It says whatever you were needing at age 75, you’re going to need at 85 plus inflation, but the reality is that spending needs to taper off,” Cook says.

And that’s where there might be some good news for retirees. Investment Trends senior analyst Recep Peker says their research has found that there is a gap between how much people think they will spend in retirement and what they actually do – which is spend significantly less than anticipated.

Filling in the shortfall

For many Australians, having calculated what they will need for retirement, they will be faced with a shortfall – and that is assuming they live to average life expectancy.

For those who live longer, the situation might get more serious.

Research released by the Financial Services Council (FSC) earlier this month shows a $1.063 trillion shortfall in total retirement savings for Australians who live longer than life expectancy, rising to $1.227 trillion for those who outlive 90 per cent of their peers.

These are headline figures that may not mean much to the individual, but some modelled examples bring the reality home.

A 50-year-old earning $61,700 per annum will have a personal shortfall of $170,906 if he outlives 75 per cent of his peers, and a 30-year-old female who is currently earning $53,500 will have a personal shortfall of $292,261 if she outlives 75 per cent of her peers.

While there are plenty of strategies planners can consider in terms of product and asset allocation to try to fill in this shortfall, perhaps the most obvious solution is encouraging Australians to work longer, as FSC chief executive John Brogden suggested on the report’s release.

“Extending working lives will make a dramatic impact on retirement savings. Our research shows that for every additional year Australians work, the national superannuation savings gap is reduced by $200 billion,” he says.

Cook agrees, saying planning to work to age 65 instead of age 60 can make a difference in a number of ways.

“It’s five years more that they’re earning an income and putting money aside. It’s also five years less they need to fund their retirement, and five years more for whatever they’ve accumulated so far can grow,” Cook says.

“When you do the maths, working a few extra years can really make what might seem a big shortfall into a doable situation.”

Retirement income strategy

While there are different schools of thought on how the right balance of capital protection, growth and income should be achieved, most now agree that retirement income strategy takes an entirely different approach to portfolio construction to the accumulation phase.

This is because the risks for retirees are essentially different from those experienced by accumulators.

According to Andrew Barnett, general manager, retirement incomes, MLC, these include a sequence of market risks, where there is a pattern of negative returns followed by positive returns, which erodes the asset base available to capture the market recovery; timing risk – retiring in a poor year; and longevity risk – the risk you will outlive your money.

He argues that the current range of retirement income products are not geared towards managing these risks.

Tony McFadyen, regional director, retirement solutions, Dimensional Fund Advisors, believes the focus needs to switch from maximising wealth in accumulation to guaranteeing a minimum level of income for life during retirement.

“By focusing on building up a sufficiently large pot, there is a danger that individuals will be exposed to riskier assets at precisely the wrong time,” McFadyen says.

“So advisers need to take a more holistic and customised approach – one that focuses on setting the right goals for the individual, thinking about income needs, and taking into account longevity risk. In terms of communication with the client, it has to be less about inputs like investment strategies and more about outcomes.”

Daniel Needham, managing director of Ibbotson Associates, also sees using balanced funds as only appropriate for retirees who have sufficiently large balances to effectively self-insure for longevity risk.

“Early losses in retirement can reduce the longevity of the portfolio, so that creates some real challenges,” Needham says.

“In retirement, you want real capital preservation, you want to maintain the real purchasing power of your savings, and at the same time, you want to be able to fund as much of your ongoing retirement expenses out of the income that’s paid on the portfolio.”

Needham says that as an alternative to using products that are “pigeonholed” into certain asset classes, he sees a gap in the market for a diversified portfolio combining equities, property, infrastructure, bonds and cash, but which offers the flexibility to change exposures as required to achieve capital preservation.

“You don’t want to have high exposure to assets that could fold quite significantly. You also want to have a sustainable yield, and ideally that’s coming from a source that tends to keep up with inflation,” Needham says.

“If you can build a portfolio of assets that have those qualities, then you can potentially provide a product that is low risk, is much more fitted towards meeting the needs of a retiree, but isn’t as hamstrung around always having to have a certain amount in Australian or international equities.

"What’s happening now is that the risk profile of a lot of the balanced products is just not right for retirees, and so therefore they need to look at getting guarantees either via variable annuities or capital guaranteed products, and you pay a lot for that protection,” Needham says.

At the mercy of the market

Market volatility over the past five years has definitely changed the way portfolios are constructed for clients in retirement, according to Jordan.

“Most people are scared of running out of money they have worked so hard for, they just want to enjoy the lifestyle that they hoped for,” he says.

“It’s our job to try and protect as much of that as we can and still try to get the right mix for them”.

Mitton agrees that the general level of optimism amongst clients about their retirement has declined, which has brought a greater level of awareness, engagement and vigilance about decisions.

Richard Howes, chief executive of Challenger Life, believes the recent ups and downs have also forced a rethink of retirement strategy for many people.

“We are seeing a noticeable shift in focus from long-term wealth creation to a focus on long-term income certainty,” Howes says.

“The volatility, together with the Baby Boomers just starting to retire, is calling on the industry to adapt and to start thinking about the super system in the way it’s really intended to be, which is a retirement income system, not a wealth accumulation system.”

The toolkit

When it comes to what investors want from their retirement incomes products, Investment Trends has found that ease of accessing money, ease of understanding, and tax effectiveness are the most important attributes.

With the Australian retirement incomes product market being “fairly underdeveloped” (as Needham refers to it), the main choices currently are allocated or account-based pensions and annuities.

Within the annuities space, there are lifetime annuities, providing inflation-adjusted lifetime earnings; variable annuities, which combine an annuity and balanced product backed by a derivative structure to minimise downside investment risk; and annuity bonds, which are inflation-linked and issued by the Government.

Reflecting the fact that our retirement incomes system is still thinking in “accumulation mode”, Howes says, the most popular product is still the allocated or account-based pension. But retirees need to be aware of the impact of market instability on their balances.

“That’s an additional challenge for individuals – the way they drawdown and budget during some periods, because it is not an easy, smooth path,” says Clare.

Allocated pensions also can’t promise a certain known return.

“All you can do is put the money into asset classes such as fixed income and target a particular outcome,” says Howes.

“What we’ve seen increasingly is that planners and their clients are preferring instead to get certain known returns from products like annuities.”

Are annuities the answer?

With client anxiety about capital loss reaching a peak, some planners are turning to annuities as a way of providing some guarantees.

The Investment Trends December 2011 Retirement Planner Report showed that in 2011, 54 per cent of planners said they provided advice on annuities – up from 46 per cent in 2010 and 42 per cent in 2009.

In 2011, 36 per cent of planners had placed new client money in annuities, with 49 per cent saying they intended to do so in 2012, with lifetime annuities receiving the most interest.

In their favour, annuities offer explicit longevity, inflation and capital protection, and return certainty – attributes offered by no other product apart from the age pension, according to Howes.

He says advisers are adopting a “layering” approach, using the age pension as a base, and adding a private pension or annuity on top to guarantee a certain level of income for clients.

“That’s liberating for the client and for the adviser, and it’s liberating for the rest of the portfolio because it gives growth assets time to grow,” Howes says.

“Their job is to achieve their operational targets and estate planning targets, because the heavy lifting on the income side has been done.”

Traditionally, a concern with annuities is that access to capital has been restricted.

“Annuities really tie up a person’s assets for a significant period of time, so definitely the downside is that they have reduced access to their capital,” Mitton says.

Howes says Challenger has sought to address with its Liquid Lifetime product, which allows the retiree to access all or some of the capital within the first 15 years of the annuity.

However, guaranteed products can also be relatively expensive.

“Most commonly, downside projection comes at a cost and often that cost is too great when you can manage the risks for a client,” Mitton says.

While Jordan sees a role for annuities for some clients, he sees their greatest utility in enabling clients to gain some level of age pension, so they can access the associated concessions.

“One of the main advantages over time is the way annuities are treated by Centrelink, which gives the client a real boost in their pension.

"It also gives a consistent income return where exposure to the market doesn’t. That helps clients as well, because a lot of them really feel concerned about losing their capital long-term.”

New alternatives required

So is the current retirement incomes product set sufficient to provide planners with the amount of control and flexibility they need?

With many Baby Boomers planning to sell property – the family home or an investment property – to boost their retirement nest egg, Barnett says this shows that the current retirement income products aren’t really meeting the needs of retirees.

He argues that the market needs innovative products that offer a better combination of liquidity, capital stability and longevity protection, and that we could look at key markets overseas, such as the US, for some potential solutions.

“There you have equity-indexed annuities, variable annuities, fixed annuities and a very deep and broad corporate bond market,” says Barnett.

As the product range develops, Barnett sees a greater role for financial planners to move “from asset allocation to product allocation”.

“Understanding what the objectives for a retiree are – whether they want to leave a bequest, how long they expect to be active for in retirement, whether they want to plan for potential healthcare costs later in life – they can construct a portfolio based on a different set of products,” says Barnett.

“They may want a corporate bond for the first few years, followed by a guaranteed product that matures after a period of time, followed by a lifetime annuity to provide longevity.”

Given the intentions around disposing of property as a way of accessing retirement funds, Barnett also believes the market will respond with more reverse mortgage or equity release products.

Perhaps the most likely next entrant to the Australian market is deferred lifetime annuities, which has already been flagged for consideration by the Federal Government’s superannuation roundtable.

Needham says this type of product is very much needed in our system to cover longevity risk.

“What people don’t like is the risk of becoming a burden on their own kids later in their retirement. So you tend to therefore underspend and live a lifestyle less than what your assets can afford.

"So what a deferred lifetime annuity does, by being pure longevity insurance, is it allows you to consume at an appropriate level, safe in the knowledge that the risk of you living too long has been covered,” he says.

Keeping clients comfortable

With advisers expecting to see a larger proportion of their client base made up of retirees, McFadyen argues that planners need to return to first principles when planning retirement incomes – returning to key questions such as what income do you need in retirement?

How long do you plan to work? How much do you want to save?

“The role of the adviser in this scenario is not to bore people with, say, how much mid-cap European equities they need in their portfolio, but to focus instead on their lives and their needs. Everything else flows from that.

"What’s important for the individual is reaching the goal and not spending too much achieving it.”