Testing the sustainability of retirement income strategies
Minh Ly looks at modelling strategies to help advisers help clients understand how likely a desired spending level can be sustained during retirement.
Australians enjoy one of the longest life expectancies in the world and this is expected to increase over the next 40 years. Although the longevity story is not a new one, it does highlight a key challenge when providing retirement income advice: how do advisers help retirees achieve their income goals for a long time, or even a lifetime?
Additionally, market volatility, specifically the order of returns or sequencing risk, can make this task even more difficult as it can significantly impact how long capital lasts.
While retirement income strategies need to address longevity and sequencing risk, it is often difficult to test how robust strategies are against these variables. This is because of the mismatch between how markets behave in real life and assumptions used in financial modelling tools.
For example, many of today’s modelling tools use a deterministic approach when projecting strategy outcomes. They assume constant long-term market returns, inflation, and interest rates for each projected year.
However, markets behave very differently year-to-year than what long-term returns suggest. There may be years of positive returns and there may be some with negative returns.
Modelling strategies with market volatility
One approach advisers can use that factor in the impact of short-term fluctuations in markets is stochastic modelling.
Stochastic modelling ultimately produces a range of possible outcomes for proposed strategies.
These outcomes can be used to help clients understand how likely a desired spending level can be sustained during retirement.
To help advisers illustrate their retirement income strategies across a range of possible market conditions, Challenger has developed the Retirement Illustrator.
The Retirement Illustrator allows retirement income strategies to be tested against 2,000 possible market scenarios provided by Willis Towers Watson. Each scenario varies returns, inflation and interest rates each year to more closely mimic market volatility.
Case study – building and testing retirement income strategies
Max and May are both aged 65 and looking to retire in the next couple of months. They own their home and have accumulated $650,000 in superannuation between them ($325,000 each).
As well as their superannuation, they have $20,000 in personal assets and $40,000 in cash that they wish to maintain to meet short-term liquidity needs.
They want to leave their home behind for their kids and intend on using their superannuation to fund their retirement. Like many retirees, they know this won’t last forever and are worried about outliving their savings. As such they are seeking advice on how to best utilise their superannuation to achieve their goals.
After discussing what they want their retirement to look like, Max and May agree they would like an income of $60,000 p.a. for as long as possible. This will allow them to achieve their desired lifestyle.
However, they understand the need to balance this objective with ensuring they can always fund their essential retirement spending of $41,000 p.a. (an amount that exceeds the current maximum Age Pension of $34,819 for a couple, as at 1 July 2017).
On analysing their risk tolerance, they agree they are balanced investors, and are comfortable with volatility typical of a 50/50 growth/defensive portfolio.
Their current Age Pension entitlement is calculated to be an annualised amount of $8,689.
How long does cashflow need to be provided for in retirement?
Australian life expectancies have risen over the past few decades and are expected to improve further with improvements in medicine and healthier lifestyles. It is therefore important that this is factored into retirement income strategies.
The Retirement Illustrator provides forward looking life expectancy estimates by incorporating 25-year improvements in mortality rates, from the Australian Government Actuary, into estimates from the Australian Life Tables (ALT).
Using this approach, Max and May could expect to live for 23 and 25 years respectively (see Chart 1). That is, there’s a 50 per cent chance they would still be alive in 23 and 25 years. Importantly, as a couple, there’s a 50 per cent chance that at least one of them would still be alive after 28 years.
For the purposes of this case study, we will test our strategies against a 28-year timeframe. If a client is very concerned about outliving their savings, it may be more appropriate to use a longer a timeframe such as 31 years, where there is only a 25 per cent probability that at least one of them would still be alive.
Strategy one: Account-based pensions
The first strategy that can be considered for Max and May is to transfer their accumulated superannuation benefit into account-based pensions and implement a regular drawdown strategy to fund their cashflow requirements.
To achieve their overall income goal of $60,000 in the first year, they will need to draw an amount of $51,311 in addition to their Age Pension of $8,689. The amount drawn from the account-based pension can be varied in later years (subject to Superannuation Industry (Supervision) Act (SIS Act) minimums) as Age Pension entitlements change.
Projecting this strategy using a deterministic approach (constant returns), their income objectives are met for about 25 years (until age 90). This is three years short of our 28-year target timeframe (age 93) which is depicted by the red line in Chart 2.
Importantly, this means Max and May will need to rely solely on the maximum Age Pension and will not be able to meet their essential income requirement of $41,000 p.a. from age 90.
Naturally, these outcomes are highly sensitive to the market assumptions used. If higher returns were used, this will extend the number of years they are able to achieve their income goals, and vice versa for a lower return assumption.
*Growth assets returns 7.70% p.a. and defensive assets, 3.70% p.a. before management fees of 0.80% and 0.60% respectively. In addition, platform fees are assumed to be 0.50%. Interest for the $40,000 held in cash is assumed to be nil.
Applying stochastic modelling to strategy one
To help Max and May better understand how market volatility can affect their income goals, the Retirement Illustrator provides advisers with the ability to stress test strategies.
As illustrated in Chart 3, in 2,000 modelled market scenarios just 23 per cent of those scenarios were Max and May able to achieve their desired income of $60,000 p.a. throughout our 28-year target timeframe. And in only 27 per cent of those scenarios were they able to achieve $41,000 p.a. for their essentials.
This means that at some point in their retirement, there’s a very high probability that Max and May will need to rely solely on the Age Pension.
Strategy two: Increasing certainty around meeting essentials with an income layering strategy
An alternative strategy that could be considered to provide Max and May with more certainty around achieving their income goals is an income layering strategy.
A partial allocation of retirement assets to a lifetime annuity can be used to provide a client with a guaranteed layer of income over and above any Age Pension entitlement clients may be eligible for. This combination of annuity payments and Age Pension can be structured to ensure it’s sufficient to meet a client’s essential income requirements in retirement.
As a starting point, an allocation of 30 per cent ($97,500 each) of Max and May’s account-based pensions can be made to a lifetime annuity to help fund their essentials.
Under this scenario their cashflow in the first year will comprise of income from three sources, summarised in Chart 4.
Chart 5 provides a deterministic projection of their retirement income under this strategy using the same returns used in the prior strategy and highlights three key benefits:
- They are able to achieve their desired income of $60,000 for longer (until age 93 compared to age 90 in the prior strategy) and can be attributed to a couple of factors including the annuity’s efficient interaction with the Age Pension Income and Assets Tests via its deduction amount;
- Some longevity protection in the event that they live past our target timeframe; and
- Higher income in retirement beyond the point where other retirement assets are depleted – they will no longer rely solely on the Age Pension in the event their account-based pension runs out.
*Growth assets returns 7.70% p.a. and defensive assets, 3.70% p.a. before management fees of 0.80% and 0.60% respectively. In addition, platform fees are assumed to be 0.50%. Interest for the $40,000 held in cash is assumed to be nil.
Applying stochastic modelling to strategy two
Stress testing the income layering strategy in the same manner as strategy one shows a higher level of certainty around meeting Max and May’s income goals, despite market volatility within these scenarios.
As illustrated in Chart 6, in 100 per cent of modelled scenarios (compared to 27 per cent) Max and May met their $41,000 p.a. income goal and in 45 per cent of those scenarios (compared to 23 per cent) Max and May met $60,000 p.a. throughout the target timeframe.
Overall, matching Max and May’s income goals with appropriate products provides them with a higher level of certainty with meeting their core expenses, while also maintaining enough flexibility to manage unforeseen events during retirement.
Providing Max and May with certainty around their essentials can give them the confidence to spend and achieve their goals especially in their early years of retirement.
Estate planning considerations
Some clients may be concerned that a partial allocation to a lifetime annuity could impact the value of their estate available upon death.
From an estate planning perspective, Max and May’s income layering strategy also provides them with estate values similar to the account-based pension strategy.
This is highlighted in Chart 7 which compares the median estate values (in today’s dollars) of their account-based pension strategy (green) and their income layering strategy (blue).
The flexible income option of Challenger’s Guaranteed Annuity (Liquid Lifetime) provides a death benefit equal to 100 per cent of the initial investment amount for the first half of their life expectancy.
In this case, it then reduces to 50 per cent and declines linearly to zero during the second half of their life expectancy.
However, even with a reducing death benefit, Max and May’s combined estate value under the income layering strategy was broadly no different to estate values under the account-based pension only strategy.
Summary
With life expectancies expected to improve further over the next few decades, retirees will likely need cashflow for longer during retirement.
Testing retirement income strategies over the long-term can be difficult because of the mismatch between long-term assumptions used in modelling and how markets can behave year-to-year.
Minh Ly is technical services manager at Challenger.
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