With increasing demands being placed on super funds as more and more baby boomers move to the draw down phase it’s time to rethink retirement income products, Paul Rogan writes.
As more baby boomers move from accumulating super to drawing down for their retirement, it is fitting that both industry and government are taking a closer look at retirement income products.
Despite holding 94 per cent of all pension assets, the performance of account-based pensions (ABPs) throughout market cycles has rarely been examined, especially those ABPs invested primarily in higher growth but riskier assets.
Everyone agrees that we’re all going to be retired for a long time. But while a 50 to 60 per cent allocation to equities might be the key to producing a lifetime income stream for some people, the unpredictability of markets mean that others could run out of money prematurely. While ABPs flexibility is understandably lauded, the potential for the purportedly 'balanced’ variant to create retirement winners and losers is seldom discussed.
Financial System Inquiry
This makes ABP’s evaluation by David Murray’s Financial System Inquiry (FSI) panel all the more remarkable. The FSI interim report noted both the strengths and weaknesses of ABPs. It found they offered flexibility and liquidity, but did “not effectively manage risk” and are less income-efficient than lifetime annuities. On the other hand, annuities suffer from a perception that they’re not good value, and compete with the 'free’ age pension as a longevity risk solution.
While such a public critique of the shortcomings of some ABPs might have surprised many within our industry, the risks of relying too much on a 'balanced’ ABP for retirement income became obvious during the global financial crisis (GFC to the likely majority of retirees. If there’s no other source of investment income and/or drawings exceed investment returns, capital must be consumed and can only be topped up by income from personal exertion, inheritance or another such windfall. Needless to say, the prospect of re-entering the workforce at age 65 is not always a viable one.
What’s clear from the FSI interim report is that there is no 'silver bullet’ retirement product, despite ABPs domination of retirement flows and pension assets, and despite recent annuity innovations which address their traditional lack of liquidity. That “one-size-does-not-fit-all” should come as no surprise to retirement advisers who’ve long used both ABPs and annuities to serve complementary purposes within retirement portfolios.
There is now a clear consensus that more innovation and choice is desirable, especially in the longevity product space, but ongoing debate as to how market and longevity risk are best managed. Of course, reliable “annuity income” seems to be sought by all; from the proponents of “bell and whistle” products like variable annuities to advocates of non-guaranteed, “best-efforts” concepts like pooled “annuity schemes”, to the champions of investment strategies such as “dynamic asset allocation” and “constant proportion portfolio insurance”.
No short cuts
Of course, actuaries would argue that when it comes to longevity risk, there’s no free lunch; an annuity is either a capital-backed, lifetime guaranteed income stream - or it isn’t. The chequered track record of defined benefit pension schemes around the world seems to prove that there are no short cuts or free rides - retirement is likely to be long and expensive, and requires more capital than you might think.
For behavioural reasons, the bigger question might be whether any new longevity product or strategy should be designed top down, based on academic and industry research - or bottom-up, based around understanding members’ needs and wants.
Remember that our entire super system is predicated on a behavioural observation; that people won’t save enough for their retirement and need to be compelled to do so. So in the retirement phase, we need to ask, purely from a market acceptance perspective, does it make more sense to educate risk averse and sceptical retirees about untested theories, or should we try to make boring but reliable and proven products more attractive?
Based on Challenger’s experience in reviving the lifetime annuity market over the last five years, our view is that any new retirement product should be grounded in an understanding of the realities of everyday retired life.
Consumer quantitative surveys are a good starting point. Research from Investment Trends last December found pre-retirees regard tax effectiveness, simplicity, lifetime income, low cost, and access to capital as the most important qualities of a retirement income investment.
For actual retirees, the list was more conservative. Security in the form of a strong product provider topped the list, followed closely by access to capital, simplicity, reputation and tax-effectiveness. Importantly, loss aversion in retirees is acute, not just because people become more conservative as they age but because they are living with the reality of a fixed capital base and more limited income-producing opportunities.
Notably, control over investment choice was not nominated as a high priority by either retirees or those yet to retire - despite the fact that it’s often listed as one of the key benefits of ABPs.
The survey also challenges the assumption that members also want the highest returns in retirement. Again, this doesn’t make the top 10. Just 19 per cent of retirees list the highest returns as a priority, and just 27 per cent of pre-retirees.
Investment Trends’ work corroborates bespoke consumer research undertaken by Challenger over the last five years. Back in 2010, we began to realise that the industry’s views of what retirees wanted in a bull market (flexibility, investment choice, immediate liquidity), diverged somewhat from what retirees were saying was important to them in the aftermath of the GFC.
Realities for retirees
Challenger surveys have found capital preservation remains paramount and that post-GFC loss aversion was much greater than the industry thought. One survey found just nine per cent of advisers strongly agreed that capital preservation was retirees’ prime concern. But when the same statement was tested among retirees themselves, four times that proportion - 36 per cent - said they strongly agreed.
Again, it’s one thing to talk about retirement investing, it’s another thing to live it every day. While fund managers and advisers sat in their offices discussing asset allocation, retirees were watching their retirement savings fall, knowing they had little time or in many cases, ability, to top it up. Many knew people who were forced to delay retirement, return to work or slash their household budgets to get by. They saw first-hand that for those in retirement and unable to return to the workforce, their options were limited and quality of retirement was diminished.
A 2013, Challenger and National Seniors Association poll of 3500 NSA members showed that retirees still had a very conservative attitude toward financial risks. They didn’t view risk in terms of volatility, standard deviations, or benchmarks. They focussed on the consequence of a risk manifesting (ie running out of money), than its probability of occurring.
Almost two in five (37 per cent) said they could not tolerate any losses on their investments. Only 13 per cent said they could handle more than five per cent in one year.
When asked the highest priorities for a retiree today (besides health considerations), retirees talked about longevity risk, peace of mind, the need for a regular and dependable income in retirement, and protection against inflation. More than 55 per cent were worried about outliving their savings, and contrary to popular perceptions, leaving a bequest rated a low priority.
So rather than reinventing the wheel, Challenger decided it was worth taking a second look at a product than ticked all the boxes retirees want, but that had proven unpopular - lifetime annuities.
It was clear from the research that retirees wanted all the good things a lifetime annuity provided, but none of the bad. The main problem retirees had with traditional annuities was giving up access to invested capital. Although liquidity needs could be met by a complementary ABP or cash, it was clear that the secure feeling provided by near-at-call access to all of their capital outweighed the security of lifetime income.
Moreover, while it is highly unlikely that anyone will be run over by a bus immediately after taking out an annuity, there existed a perception that if you didn’t live longer than your life expectancy, the insurance company would “win”.
This wasn’t helped by the fact that many people misinterpret life expectancy to mean “when I’m likely to have died” rather than a median age beyond which half of their age and gender cohort will live.
Our initial product design brief addressed these fears and behavioural biases head on. For a male aged 65 at purchase, we decided to provide a guaranteed level of capital access during the first 15 years, and a decision point at age 80 when the investor would be better informed about their likely longevity. We believed, and still believe, that most retirees don’t expect to use at-call liquidity, but they place a high value on knowing they can access their capital if need be.
The trade-off for this feature is lower income that would be generated from our standard lifetime contracts. Retirees forego some income (typically about $1100 per annum) for the peace of mind of accessing their capital. Strong sales have indicated retirees are prepared to pay for a guaranteed return and can have access to liquidity and market returns from other investments.
Contrary to another widely held perception, we also found that lifetime annuities don’t have to be an all-or-nothing proposition. Retirees don’t need to invest all their assets to generate a reasonable guaranteed income.
Analysis by Mercer found annuities can help solve what it terms the 'retiree’s trilemma’ - the competing trade-offs in balancing the demands of the need for income, against the need for access to capital, against longevity protection. It concluded many clients could benefit from partial annuitisation of their retirement portfolio, which could also include account based pensions and even deferred lifetime annuities that kick in later in retirement.
The reinvention of the lifetime annuity and rethinking its role in retirement holds a clear lesson for industry and policymakers grappling with retirement product design.
Instead of “building it and they will come”, instead of inventing new, more complicated products to address the risks in retirement, we need to listen to our customers. They have told us what they want: capital preservation, a reliable, inflation-proofed income for life, transparency, simplicity, and low or no fees.
With self-managed super continuing to grow, retail and industry super funds and retirement advisers may only get one chance to prove to their retiree clients and members that they understand who they are and what they want. As an industry we need to make the most of that opportunity.
Paul Rogan is Chief Executive of Distribution, Product and Marketing at Challenger.