Globally, retirement income systems are shifting from defined benefit (DB) to defined contribution (DC). One main consequence is the risk transfer to the individual who now has to solve what Nobel economist William Sharpe called the “nastiest, hardest problem” in finance – effectively and efficiently converting retirement savings in a DC fund to retirement income.
This nasty, hard problem is using their retirement portfolio to manage the complex task of balancing their desired lifestyle against an uncertain lifespan while navigating market volatility, inflation, and changing healthcare needs.
Solving the DC conversation challenge requires support and guidance mechanisms, as well as suitable retirement income solutions. While we might be ahead of the rest of the world regarding the proportion of assets in DC schemes, there are plenty of lessons from how others approach both aspects.
Support and guidance mechanisms
While we wait for Tranche 2 of the Delivering Better Financial Outcomes legislation, we can get some inspiration from some of the ways the UK supports those ready to transition from full-time work.
The distinction between regulated advice and information and guidance is difficult to navigate in Australia. The UK has an explicit concept of an advice guidance boundary: the regulatory distinction between providing regulated financial advice and offering general information or guidance. It is designed to provide clarity for both consumers and providers. The Financial Conduct Authority, the UK’s corporate regulator, is currently reviewing how it operates and its Policy Paper Advice Guidance Boundary Review – proposals for closing the advice gap, is a good starting point on how the boundary works.
The other UK initiative worth considering is MoneyHelper Pension Wise, which offers free, impartial guidance to over 50s to explain the options available for their defined contribution pension pots.
The recent Treasury discussion paper on superannuation in retirement called on superannuation funds “to enable members to make the mindset shift necessary to confidently draw down on their superannuation in retirement”.
One of the conclusions of the 2023 edition of the TIAA Institute GFLEC Personal Finance Index is that if we want to create better retirement outcomes, we need to help people understand how long they are going to live in retirement. That is, better longevity awareness leads to better retirement outcomes.
The Canadian Institute of Financial Planning and FP Canada Standards Council jointly publish the Projection Assumption Guidelines to help financial planners make realistic financial projections. Recognising the importance of longevity awareness, Canadian financial planners can use these guidelines to estimate a projection period where the probability of outliving their capital is no more than, say, 25 per cent.
Suitable retirement income solutions
On the product front, given the greater familiarity with DB schemes in other countries, there appears to be a broader acceptance of using pooling to solve for longevity risk.
In Europe, collective DC arrangements are being deployed to balance individual ownership with group risk-sharing. In the Netherlands, the transition from DB to collective DC is happening at the country level with the reform of the Dutch pension system. In the UK, the Royal Mail recently launched a collective DC scheme designed to offer employees a cash lump sum and an income in retirement.
The traditional lifetime annuity is still offered widely in North America, but more alternative lifetime income products are emerging, often referred to as “modern tontines”. These products reimagine the historical tontine principles where surviving members in an investment pool inherit the deceased members’ shares.
A modern tontine pools longevity risk among members, and survivors benefit from “mortality credits”. They are primarily at the concept stage in the US, but some examples have been launched in Canada, including the GuardPath Longevity Solutions and the Longevity Pension Fund.
The importance of sharing and learning
We are all tackling the same nasty, hard problem but from different starting points influenced by social, economic, and cultural factors. Our solutions can only get better by sharing with and learning from other systems.
Stephen Huppert is an independent consultant and advisor partnering with institutions committed to improving the retirement outcomes of Australians.
