Flawed thinking on retirement products must change

Why does the investment industry continue to fail so many retirees? And how many crises will it take before our industry changes? Yet again, retirees have been let down by retirement products based on outdated thinking for a different world. 

Australia’s 3.9 million retirees deserve better. Some 12 years on from the Global Financial Crisis and the vast majority are still subject to the share market rollercoaster. Yet they tell us they want peace of mind, not wild wealth swings that not only damage their financial health but their personal wellbeing too.

For too long, our industry has told people to invest for the long term, diversify and take less risk as they age. But that is not enough to protect retiree wealth during crises.

We need the industry to adopt genuine innovation that puts retiree behaviours and specific retirement risk at the heart of investment product design. Innovation, that responds to a world of persistent higher volatility and lower growth – in the context of an ageing population. Innovation that retirees tell us they desperately want. 

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REDEFINING RISK

I see three related flaws in many traditional retirement-investment products. First, our industry spends millions trying to deliver solutions for current and prospective retirees, yet consistently delivers similar products inadequate to their needs. 

Too much focus is on wealth accumulation and returns, and not enough on decumulation as retirees draw down savings. 

When our industry talks of risk, it refers to volatility and standard deviation – sadly both are foreign and irrelevant concepts to most retirees. 

Allianz Retire+ research shows “running out of money” is the biggest retiree fear. In one of our surveys, almost two-thirds of respondents feared this more than death. This is never used as a risk metric and is really the only one that matters.

ALIGNING PORTFOLIO CONSTRUCTION TO RETIREMENT RISK

This critical misconception of risk creates the second flaw: moving to overly conservative asset allocations as retirees age. Holding lots of cash and bonds magnifies the risk of retirees running out of money in a low-yield world. 

Research undertaken by Callan Associates shows in 2004 a 50/50 split of growth and defensive assets would achieve an expected return of 7.5%. However, to achieve the same return in 2019, the portfolio would have to consist of mostly growth assets, with a mere 4% allocation to defensive assets. Simply put, portfolios and strategies that used to work in a high interest rate world, don’t work anymore. 

Lonsec Investment Consulting recently challenged the measure of risk in retirement and the optimal combination of bonds and equities. They replaced volatility as the traditional risk measure with “the probability of running out of money”.

Portfolio theory assumes equities offer the highest risk and returns. However, when “running out of money” defines risk, equities offer the lowest risk and highest returns.

Why? Holding equities reduces the risk of running out of money in retirement.

Conversely, a portfolio of only bonds has the highest risk of retirees running out of money. 

Retirees must hold more equities for their money to last longer in a low-yield world. But more needs to be done to help retirees be fully or partly shielded from market shocks.

ADEQUATE PROTECTION IS VITAL

This highlights the third flaw: lack of adequate protection. It’s all well and good to say that a growth portfolio reduces the risk of running out of money in retirement, but it also opens up the retiree to another retirement risk – sequencing risk. 

Our industry does little to mitigate sequencing risk – that is, being subject to a market downturn at the worst possible time. For example, holding equities during a market crash and having to drawdown on investments that have fallen in value, as one stops working.

Since we know that moving to conservative assets isn’t the answer, it would suggest we need a higher allocation to growth in retirement portfolios, but there has been little opportunity to manage both the risk of running out of money and sequencing risk simultaneously. Retirement specific behaviours compound this issue, particularly loss aversion.

We know retirees feel the pain of an investment loss up to 10 times more than the joy of a gain. Yet our industry is yet to factor in retirement savings products that provide exposure to equities, deal with sequencing risk and address loss aversion through adequate protection. 

DEVASTATING OUTCOMES

These flaws have real consequences. When retirees fear the future, they spend less and avoid drawing down on savings. They live frugally to “self-insure” against running out of money.

When retirees feel their savings are at the mercy of global markets, some become confused about the safety of their investments and are likely to make knee jerk decisions which can have devastating long-term consequences. Four-in-five retirees felt their investments were not safe during COVID-19 while one-in-three prospective retirees had more negative expectations of retirement as a result of the pandemic.

How much longer can our industry ignore the obvious? Retirees must hold a larger allocation of higher-growth assets as they age and that is only achievable if retirement products can genuinely protect retirement income, and a stronger culture of wealth protection develops.

Nobody wants retirees to fear the future or have less dignity in retirement. Or force them up the risk curve to achieve higher returns, without adequate protection. One-in-three prospective retirees in our research said they would consider a product that insures them from market downturns. A telling statistic of just how “at the mercy of share markets” they must be feeling. 

Let’s hope the Retirement Income Review helps address these issues once and for all and that more retirees seek financial advice and use investment products that reflect a changing world. 

Jacqui Lennon is head of product and customer experience at Allianz Retire+.