Embracing innovation in the retirement incomes space

The financial services industry’s approach to post-retirement has long been regarded as stale. Critics’ voices have become ever louder and, as Janine Mace reports, the industry seems to be responding with a new focus on innovation in the retirement income space.  

For many years post-retirement has been the sleepy corner of the financial services market.  

Earnest discussions about adequacy and friendly chats with elderly clients have largely been the order of the day.

As asset inflows continued to rise steadily, most of the industry’s attention remained firmly focused on the lucrative wealth accumulation side of the business.  

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But with large numbers of baby boomers now heading into retirement, the conversation is turning to what happens when people start drawing down on their assets – not building them up. 

The Association of Superannuation Funds of Australia (ASFA) recently released a white paper on the future of Australia’s superannuation system, calling on the industry to begin a detailed conversation about the different issues and challenges inherent in the post-retirement phase. 

According to ASFA chief executive, Pauline Vamos, there are a number of tricky issues that need to be navigated in relation to retirement incomes. 

“Superannuation is just one part of this puzzle. The role of other factors such as aged care, health care and access to the age pension must also be considered when contemplating the system’s design,” she said. 

As reported in Money Management recently, Vamos has also called for the creation of a specialist qualification in post-retirement advice to appropriately deal with the complexity of providing advice in this life phase. 

“It is about meeting the different needs associated with the changing nature of retirement as people get older,” she said. 

More discussion needed 

Vamos is far from alone in her call for more discussion about retirement incomes. 

Research house Lonsec has also been vocal on the need for a new way of thinking about the issues, calling on advisers and investment managers to review their existing attitudes to retirement planning if they are to effectively meet the financial needs of the baby boomer cohort.  

According to Lonsec’s head of investment consulting, Lukasz de Pourbaix, the shift in emphasis from accumulation to draw-down represents an important change. 

“The whole industry is based on the accumulation phase and now baby boomers are reaching retirement, it is at a crossing point, as the objectives and cash flows change as clients shift to retirement.” 

He believes the entire industry needs to step up when it comes to retirement income and its associated products. 

“People have relied upon product providers and this piece is important, but it is the end game. The opportunity is in the strategies that link to the risks and finally, the product chosen. This fits in with the FOFA [Future of Financial Advice] approach,” de Pourbaix notes. 

“Consultants have not taken the lead in this area and product providers have driven the thought leadership - and that needs to change, with everyone becoming involved.” 

Stephen Huppert, a partner in Deloitte’s Actuaries and Consultants business, agrees there has not been enough discussion. 

“The Australian superannuation system rates very highly in the global context and it is a great system in the accumulation phase, but not enough work has been done on the draw-down phase.” 

Huppert believes more debate and thought is required about the products and strategies needed for retiree clients. 

“As an industry, we need to have the conversation about the need to do better in the post-retirement phase.” 

However, he acknowledges the problem is not just a local one. 

“There is a global problem about how to deal with retirement and longevity risk. It is not just confined to Australia.” 

The solution is not only new product development, but encompasses a range of areas, Huppert says. 

“There is no silver bullet solution to the problem. We need better advice, better products and the right tax environment to allow people to draw-down in the right way.

"Post-retirement is about financial products, but it is also an important part of Australia’s social capital and how sustainable it is in terms of tax and the incentives that are provided.” 

The debate about retirement incomes is an important one for advisers, as nearly 46 per cent of their client assets are held by retiree clients, explains Investment Trends senior analyst, Recep Peker.  

Advisers are increasingly recognising the significance of retirees and retirement incomes to their business, according to Investment Trends’ December 2012 Retirement Planner Report. 

“Our research found 41 per cent of planners expect retirees to play a bigger part in their business by 2015,” Peker says. 

The study also found advisers expect to be providing more advice on areas such as healthcare, bequests and estate planning in the years ahead. 

Huppert believes advisers have a vital role in this area, whether through scaled, intra-fund or personalised advice. “Planners need to be aware of the new products and ideas in the industry.” 

Longevity risk in focus 

Although there is agreement about the need for more thought about retirement incomes generally, there are mixed views about the key risks advisers should mitigate for their clients.

Some experts believe the focus should be on the risks from increasing longevity, while others believe sequencing risk and underfunding are the key issues.  

For John McClusky, managing director of NAB’s Global Markets Investment business believes, funding the growing life expectancy of Australian retirees is the biggest challenge. “The longevity question is increasingly important,” he says. 

Tim Furlan, director of superannuation at Russell Investments, believes there are five strategic risks that need addressing. 

“People need to put enough into superannuation to have enough to live on, but they also need to retire at the right time, they need the right draw-down level, they need to invest in the right way to avoid sequencing risk, and they need to manage longevity risk.” 

He believes longevity risk is a “fifth order” thing when it comes to retirement incomes, as investment issues in early retirement can wipe out a client’s capital long before the risk of living too long kicks in.  

“All the talk about longevity risk is important, but it is missing the critical part played by the early retirement phase. For advisers, strategy planning issues are the first three issues and are the most important. The next issue is managing investments the right way and avoiding a bad early investment retirement experience,” Furlan argues. 

“The 10/30/60 rule is very important for retirement, so you need to invest throughout retirement and keep managing risk. The compounding effect of sequencing risk and draw-downs is very significant, as there are no contributions going in during retirement.” 

Accumulation to drawdown 

McClusky agrees the years just prior to retirement need far more attention when it comes to retirement income planning. “The market is not really there on sequencing risk and understanding the implications of it,” he acknowledges. 

“If we do not solve it, the Government will have investors facing a huge tail-risk in their last years before retirement.” 

Huppert is more upbeat. “We are increasingly seeing products to address sequencing risk that shift the asset allocation as the member ages and the balance changes.”  

The fresh debate about retirement incomes is seeing a reconsideration of the traditional focus on wealth creation in product design. 

“Many solutions are still underpinned by the accumulation mindset. This mindset is about growth of long-term wealth and some risk, but it is not about that in retirement,” de Pourbaix argues. 

One point highlighting how accumulation thinking dominates product design is the central risk measurement used in most products, he explains. During wealth accumulation, standard deviation is the key risk measure, but this becomes far less relevant in retirement. 

“In retirement you have income objectives, but you may also have growth objectives and generational wealth transfer and lifestyle objectives. In retirement, there are increasingly complex objectives and they are coupled with different risks. Standard deviation is not an appropriate risk measure,” de Pourbaix argues. 

He believes a lot of product and super fund objectives “don’t adequately address” these risks. 

Huppert agrees: “We think enough has been done about the pre-retirement phase and things like shifting asset allocations and the role of assets inside and outside of superannuation.  

“Now we need to understand all the risks in the pre- and post-retirement phases, such as the counterparty risk involved in longevity insurance products with structured financing.” 

More emphasis on outcomes 

The discussion about building better retirement incomes products is also feeding into the industry debate around asset allocation and outcome-based investing. 

“Superannuation is about what happens in retirement, not just about accumulation,” Huppert says. 

“Pre-GFC, the conversations were focussed on wealth creation, but superannuation should be about retirement adequacy. It must be recognised that it is not just about the last couple of basis points, but about outcomes.” 

De Pourbaix agrees an outcome focus is vital. 

“From a [retiree] client perspective, they don’t care if the product provider outperformed its peers, but they do care if they don’t achieve their objective. A lot of clients don’t pay attention to benchmarks and so are often more open to benchmark-unaware strategies.” 

However, he recognises the difficulties presented by such a shift due to the imbedded processes in the advice world. 

“Often they make compliance easy, but you must question if things like the use of risk profiling improves the process. The objective-based approach makes sense and it is too easy to say it is too hard to move away from traditional approaches.” 

Given the growing focus on retirement outcomes, McClusky believes more emphasis also needs to be placed on simplicity. 

“There is a gap around the simplicity and transparency and the availability of cheaper products for retirement.”  

In addition, more client education is needed about the potential of asset classes such as fixed interest to provide retirement incomes. 

“The asset classes that have not been prevalent in portfolios are often the ones needed for retirement,” he argues. 

“The unloved asset classes [like fixed interest] need to be thought about to put greater simplicity into asset allocation.” 

McClusky believes the industry should be looking towards the corporate bond market as a funding source for retirement income products for retail clients.

“Traditionally this market has been used by institutions, but now it can also be used to solve the longevity risk issue,” he says. 

“This suits banks and corporations, as their funding needs under Basel make these type of funding pools very valuable.” 

Where are the clients? 

In all this soul-searching, what clients actually want in terms of their retirement income can seem like an afterthought, but Furlan believes their desires are fairly simple. 

“Clients and individual superannuation fund members are looking for products that don’t force them to be locked in, as they want flexibility and they want help with the retirement process as it is challenging,” he says. 

For McClusky the answer is also straightforward. “Simplicity and transparency through the product. The lack of transparency was the big mistake leading up to 2008 and now people want simplicity and transparency about how products work.” 

All super fund members are looking for is a comfortable retirement outcome, Huppert argues. “From a member perspective, they want retirement adequacy. In the early phase they want to use their savings and then have insurance you can buy for the later years.” 

According to Richard Howes, chief executive of Challenger’s Life business, a secure income is the key. “More than anything else, retirees want to know that a base level of living standard will be sustained no matter how long they live and no matter what the market or inflation does.”

He says this is the driver for increasing interest by super funds in the annuities space as it allows them to provide members with certainty of income in retirement. “Our partnership with QSuper in February this year and MTAA/Met Life are examples of this.”

Many pre-retirees are yet to be fully exposed to retirement income products, as  until now, many funds have only had small numbers of members in retirement. 

“Many funds have small numbers of members in retirement, so often they only offer simple account-based pension products,” Huppert explains. 

“Some funds have low income and low balance members, so they only need simple solutions. However, funds are increasingly thinking about it and about what members need and want in retirement.” 

He believes the industry will see more product development. “There is not one solution that fits everyone. It is also about how you can blend the product with the age pension, as 80 per cent of Australians still have some age pension as part of their retirement income.” 

Rolling out the products   

This is unlikely to deter product providers, particularly as many advisers believe their retirement product requirements are not being met. 

The Investment Trends report surveyed 866 advisers to uncover their perceptions around the available retirement income products. It found half wanted to mitigate market risk for their clients and felt they did not have the protected products they needed. 

“Also, 32 per cent wanted to mitigate longevity risk, but don’t feel they have the products to do so,” Peker notes. 

Looking at specific products, the report found growing interest in annuities. 

“When it comes to annuities, 27 per cent of advisers used annuities with clients in 2012, and our research indicates increasing interest, with 56 per cent likely to use annuities in 2013.” 

For protected products, Peker says 73 per cent of advisers have recommended them to retirees and three-quarters are open to making that recommendation. 

Howes agrees there is growing interest in annuities, largely due to the favourable macro trends.

“The ageing demographic, increased longevity and changing investor preferences are increasing the appeal of annuities to retirees.”

Challenger has targeted $240 million in lifetime annuity sales in 2013, an expected increase of 420% on the previous financial year

“Annuities comprise less than 5 per cent of the $59 billion flowing from accumulation to retirement in 2013 and because annuities are the only available product that adequately addresses market, inflation and longevity risk, we feel the appeal of annuities will continue to grow,” Howes says.

“Annuities are increasingly being used by advisers in income layering strategies in order to provide the bedrock income needed to fund a minimum acceptable standard of living. This liberates the adviser to invest other funds in growth assets in order to deliver more aspirational goals.”

The experts believe the area most likely to see new product development is around longevity solutions. 

De Pourbaix believes longevity risk will be a key driver of product development. 

“Protected-type products for insuring against longevity risk are needed. Also, real return-type funds which are targeting retirees in the 0 per cent tax bracket.” 

Huppert agrees this area is likely to see more product development work. 

“There is a greater awareness people are living longer due to the higher understanding of longevity risk,” he says. 

This will result in more pressure for appropriate solutions and will highlight the gaps in this product area, Furlan says.

“From the product provider side, the industry is not particularly well prepared and has a long way to go to have appropriate longevity type solutions available.” 

Despite this, there are questions about the creation of a profitable solution.  

“The question of course is if an insurance product is available that provides some income for longevity, will people want to buy it? Product providers are not going to develop products if they are not going to have a big market,” Huppert notes. 

Product manufacturers are starting to respond to the growing discussion about retirement solutions.   

“Many managers have suitable products but they are not all called retirement products, so they are being tweaked to show they are applicable for retirees,” de Pourbaix notes. 

“We are starting to see interesting things in strategies and products, and not just annuities. Things like multi-asset funds and Australian equities tax funds which suit 0 per cent tax-paying clients.”  

Given Furlan’s view on the importance of investment, he believes this is an important development. 

“For the early stage of retirement, multi-asset investment products can help manage the downside risk and sequencing risk. In the late retirement phase it is not deferred annuities, but keeping open the option to buy an annuity later in life,” he says.  

Furlan believes the solution for retirees is not new products, but rather, a new approach. 

“More work needs to be done on how unbundling of the insurance and investment parts can be done. Why not pick the best-of-breed investment manager and the best-of-breed manager for the insurance component?” 

Seeking sequencing solutions 

The other hot area of product development is around solutions for sequencing risk. The driver for this is simple. 

“A comfortable retirement shouldn’t be determined by the timing of your retirement,” Huppert explains. 

According to McClusky, many pre-retirees have given very little thought to the concentration risk inherent in their Australian equity portfolio after years of saving for retirement. 

“We want to give people annuity and inflation solutions to lessen sequence risk.” 

He believes there is a serious lack of fixed interest products designed for the retiree market in Australia and argues debt market securities have a big role to play in mitigating sequencing risk. 

“This is a huge part of what is needed to solve the retirement income issue. We need to give investors more options.” 

McClusky believes greater focus is needed on getting debt securities efficiently into the sub-institutional market, similar to the situation in the US and Japan. 

NAB used this idea to develop a new retirement income product. 

“We have built an annuity term deposit product for a 5-10 per cent allocation in an investor’s portfolio,” McClusky explains. 

“The cash flow is known and it is a very simple product with a $50,000 minimum. It offers a simple solution with a term of one to 10 years and a return consisting of principal and coupon.” 

For McClusky, the simple structure of the product highlights where the industry should be heading.  

Huppert agrees simplicity is important. 

“Often the available retirement products are not easy products to understand and are difficult to explain to clients,” he said. 

McClusky sees greater efficiency in retirement income products as essential.  

“The profit margins from retail investors buying superannuation are going to shift, so providers will need to lower their profit margins and learn to deliver product more efficiently.

"The race to technology is not over and investors will want lower administration costs and simpler delivery of products, and the industry will need to respond,” McClusky explains. 

Evolution not revolution? 

In de Pourbaix’s view, new or better products are not really the solution. 

“The market environment has changed as there is increased uncertainty and volatility, and this is making strategies more important.” 

This is an important change for advisers to grasp. 

“If you talk about strategies, it helps to take control of the conversation and you talk less about what the market is going to do,” he says. 

Huppert also has concerns about a focus on retirement product creation. 

“There is not a single product that will solve the problem, with advice and education also needed to help people deal with retirement challenges.”  

He believes the retirement income product suite does not require new entrants – other than the promised deferred annuity – but rather a tweaking of what is currently available to better suit retiree needs. 

“The range of existing products and the range of investments within those products need to evolve,” Huppert argues. 

“We also need to see increased tax awareness in products for the post-retirement market, as this can be a zero tax environment.” 

Furlan agrees: “There are solutions out there and often they are not hard or costly and you don’t need to lock people into products. But the industry has not done it yet.” 

He believes the best approach is not an all-encompassing solution. 

“It could be disaggregating the longevity and investment parts, as this will allow for evolution and product improvement. It could start with products for investment in the early retirement phase, and then others for the later phase that are handled separately, as separating the two is easier.” 

Retirement income for aged care 

Another aspect of retirement income advisers will need to consider is funding for aged care. 

Huppert believes this problem is appearing on the radar. 

“The industry is starting to realise the connection between retirement and aged care. But it is still at a very early stage of discussion on the connection between aged care, health costs and superannuation.” 

The Investment Trends report found advisers have recognised this trend and are expecting retirement income advice to increasingly include issues such as aged care funding.

Although 77 per cent provide this advice now, 90 per cent will provide it by 2015. 

“Planners report more interest in providing advice on aged care,” Peker notes. 

Louise Biti, director at Aged Care Steps, agrees advisers are increasingly recognising this is an important advice area for retiree and pre-retiree clients and clients with elderly parents. 

“The rising pressure on individuals to fund their aged care costs is resulting in more elderly Australians and their families planning for their aged care needs with the guidance of their professional adviser,” she says.