A simple, flexible and robust retirement income solution is staring superannuation funds in the face but trustees have failed to notice it because of entrenched myths and misconceptions surrounding what Australians want and how they behave in retirement, according to Michael Rice, chief executive officer of consulting firm Rice Warner.
Rice says that once those myths are cleared away, the path towards developing a retirement income solution becomes much clearer.
“One of the real problems we have is, how do you find solutions when everybody starts with a bunch of misinformation that’s incorrect?” Rice says.
A solution requires nothing more than for a superannuation fund to convert a member’s account-based pension into a distributing trust, with separate cash and capital accounts, and to make pension payments from the cash account. These payments could easily exceed the income from an annuity, and would also go very close to meeting the minimum pension drawdown requirements.
Long-term strategy
The capital account can then adhere to a long-term investment strategy suitable for the member’s life expectancy, including investing in property, infrastructure and equities to capture the expected illiquidity and risk premia.
“Most of the funds, with very little administrative difficulty, could adopt this quite quickly,” Rice says.
“So the first thing is, recognise that members have two needs: certainty of cash flow for consumption; then they want the growth of their capital so the future cash flow will be sufficient to meet their expenditure needs, which are inflated.
“They obviously have competing investment objectives. You can’t do them both through a standard single-option investment strategy.
“What we’re saying is, if you were to turn your account-based pension into a distributing trust, so all the income, dividends and rents were moved to the member’s cash account, and the fund was to convert the franking credits into cash – what they do at the moment is bury it in a tax reserve somewhere – and give it to the members, move it into cash as well – it’s a little bit of a loan because you do not get your franking credit, really, until you do your tax return 18 months later, but the funds can work all that out.
“The running yield on funds is about 4 to 5 per cent, and once you’ve got that running yield you’re actually very close to the payments people are making [from pension funds] at the moment.
“If the member were to draw a pension at close to the minimum rate, which is no more than they get from an annuity anyway, they would then be drawing all their pension payments from a cash account, and the capital would be untouched. If you think about a fund having all this capital not being drawn down, they can then invest in infrastructure and long-term investments, because they’ll have their liquidity under control.”
Matches behaviour
Rice says the proposed solution matches people’s actual behaviour in retirement, and would be an appropriate default pension arrangement.
A retirement income solution needs to address a wide spectrum of risks, including investment, longevity, and inflation risks, liquidity requirements, income needs and potential late-life health costs.
Rice says that as a starting point superannuation fund trustees must ditch the preoccupation with avoiding short-term negative returns, understand better the difference between risk and volatility, and invest appropriately.
“When people can’t access their money until the preservation age, what difference does it make if it goes up or down?” Rice says.
“One of the things funds confuse is risk and volatility. The fact that markets are volatile is irrelevant unless you’re cashing in; and the biggest risk is not having enough money in retirement. So if you start investing away from the right strategy, isn’t that a bigger risk?”
Rice says people become more dependent on the age pension as they get older and their retirement savings are gradually depleted. But the age pension is effectively an annuity indexed to CPI, Rice says.
Four buckets
“What people tend to do at retirement is plonk their money into four different ‘buckets’,” Rice says.
Generally, these buckets cater for providing a small lump sum; meeting liquidity needs; setting aside a nest egg; and investing for future growth.
“The funds don’t adopt this bucketing strategy, for a couple of reasons. One, it needs advice to explain it; but secondly, they do not have enough information about their members.
“Industry funds don’t know the members’ salaries; two-thirds of people are married at retirement [and funds have information on] only one member.
“Some of the thinking in developing this product is taking into account what people want to do.
“How do we create a product that caters for longevity risk and inflation, given that people are going to live on average well over 20 years, and a quarter of them are going to live over 30 years?
High growth proportion
“Anybody who said that’s my time horizon would have a very high growth proportion in their account. The problem is with starting to draw money out at the same time. So how do you use these key factors? You want the equity risk premium; you want the illiquidity premium of infrastructure and property; you want the franking credits.
“How do you get those so you’re protected against inflation and longevity risk, but at the same time be able to draw money out of the account?”
Rice says his firm has compared this potential solution against current alternatives, and all other options “compromise, and therefore fail”.
They either shift money out of growth assets; fail to cover longevity risk; force retirees to draw down capital when markets are low; shift money to cash by selling assets and therefore run market timing risk; or require complex advice for simple budgeting. Sometimes they fail on more than one count.
MYTHBUSTERS
Myth No 1: Australians are wasteful and half goes on lump sums
“The FIS interim report said that half of the benefits are taken out as lump sums, but the real number is no more than about 15 per cent,” Rice says.
“A reasonable proportion of that is put into term deposits outside superannuation. That’s just a different form of retirement savings. The problem is that people look at the APRA stats, which are a mix of all sorts of things – death benefits, money that’s taken out as a lump sum but then might be put in as a pension in a different fund – so the statistics don’t tell you much.
“The other thing, as you know, is there are twice as many accounts as members, and it’s very difficult to get the right figures.
Myth No 2: Retirees drawdown benefits quickly so they can fall back on the age pension
“The reality is the average withdrawal from a pension is about 7 per cent [of fund assets],” Rice says.
“The minimum [mandated drawdown] is 4 [per cent] up to [age] 65, 5 per cent up to 74, and then 6 per cent, and it scales up slightly. So 7 per cent is not actually 1 or 2 per cent more than the minimum. People are not gaming the system. I don’t know anyone with a million dollars who wants to spend it quickly so they can live on $32,000 a year as a couple. It really doesn’t happen.”
Myth No 3: Australians will struggle to get a modest retirement
“Those of you who read an accounting report from one of the Big Four – starting with D – that came out in June, they had a stark headline: ‘No Australian will have a modest retirement’,” Rice says.
“All their stats were based on superannuation – forget for a moment that they didn’t have the right numbers – but they didn’t take the age pension into account. The age pension alone is only $500 short of a modest retirement for a couple, based on ASFA’s figure. So everybody is going to get a ‘modest’ retirement.
“The real key is how do we get them to get an extra $20,000 a year in retirement so that it becomes ‘comfortable’?”
Myth No 4: Retirees do not draw income products
“This is usually Jeremy Cooper’s one – that we don’t have income products,” Rice says.
“An account-based pension, which what the vast majority of people use in retirement, is an income stream. It’s moved into a tax-free status, and people draw down pension payments. It’s a very flexible system and it’s actually used quite well by members, by retirees.
“So it’s a myth to say we’re a lump-sum society and we don’t have income streams. We just have a different product to the rest of the world.”
Myth No 5: Lifetime annuities are a panacea and provide good value for money
“You see people like ASFA, Institute of Actuaries, David Knox at Mercer, talking about annuitisation as saving our nation,” Rice says.
“And the Henry report actually promoted mandatory annuitisation. That will simply reduce living standards in retirement and add to social security costs. It’s not the solution.”
Myth No 6: There are regulatory barriers which hinder sales of annuity products
“There are some barriers [and] the biggest barrier is the cost of reserves and the fact that these things are invested in poor assets – less than 30 per cent growth assets for a long, 30-year horizon,” Rice says.
“It means they are not the solution. They underperform.”
Myth No 7: We need to reduce growth assets to protect against sequencing risk
“You’ve got all these lifecycle funds and people moving people out of growth, and why are they doing that? It’s because the funds were skittish after the GFC,” Rice says.
“All these members who wanted to retire and take a lump sum got a benefit difference of 20 per cent depending on the day they retirement. And they’re the ones [the media] wrote about.
“A couple of things there. If you’ve just had four years of double-digit growth, don’t get greedy, start moving your money into cash well before to need it – that’s the first clue. The second is, if that market has fallen, don’t draw your money out. Take your time and wait for it to recover.
“But unfortunately, behavioural finance tells us people always want to sell at the bottom and buy at the top. And that’s another reason why we need a default: to help people be guided properly.”
Myth No 8: Superannuation is always a good investment
“We keep saying superannuation is the best tax-advantaged investment and yes it is; but the way means testing has been structured on the age pension, there’s a tipping point where for people who may have $400,00 or $500,000, putting more money into super [means] there’s a 50 per cent tax rate because of the assets test of the age pension,” Rice says.
“What they put in, actually comes out at the other end. And I do not think the population understands that the means testing is not perfect.
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