Jeff Mitchell says knowing your client and understanding their product requirements are the keys to successfully getting them through retirement.
Australians are living longer and want to live better in retirement. The current life expectancy for a 65-year-old is 84 for men and 87 for women. This is placing an ever-increasing burden on retirement funding assets and consequently on the advice businesses and models designed to help Australians achieve their retirement funding goals.
The Government has gradually increased the qualifying age for the Age Pension and may change the Super Guarantee regulations, encouraging people to delay fully accessing pension entitlements. The recent staged Super Guarantee increase – to 12 per cent, from 9 per cent – and the prospect of further rises are positive for addressing longevity risk in the future. However, they do not help today’s account-based pension recipients. Many pre-retirees and recent retirees only started contributing to superannuation in 1992, due to the Superannuation Guarantee Act. As such, their account balances are very likely to be insufficient to fund their expected lifestyle for the extent of retirement.
‘Many pre-retirees and recent retirees only started contributing to super in 1992’
Recent retirees and those retiring in the coming decade are most at risk of a retirement funding shortfall. Financial advisers face the challenge of managing investors’ longevity risk, while delivering desired outcomes and sound investment advice. However, the number of advice, strategy, and product options available to them to help mitigate this risk is growing.
The majority of people retiring this year will fund their retirement using account-based pensions, where they assume the investment risk and inflation risk, and not defined benefit plans, where the provider bears the investment risk.
Products designed to address longevity risk
The global financial crisis made it apparent that traditional products and portfolio construction techniques applied to accumulators were lacking when dealing with a client in pension phase.
Subsequently, a range of products/strategies have been brought to market, falling into two main categories:
• Insurance-based capital-protected; and
• Lower volatility and income products.
Insurance-based products include:
• Annuities, immediate and deferred;
• Variable annuities, immediate and deferred;
• Structured products with absolute or limited capital loss guarantees; and
• Platform-based portfolio protection insurance products.
These products are designed to transfer the investment risk from the client to the product provider, not unlike the defined benefit structures.
Income-type products include:
• Equity income strategies using long-only and derivative strategies;
• Fixed-income strategies focusing on income generation from credit and multi-sector exposures;
• Inflation-linked products designed to protect purchasing power; and
• Asset-allocation products controlling risk (capital volatility) through active/dynamic asset allocation. These products generally have a CPI or “cash plus” objective.
Advice options
As a person approaches retirement, “needs analysis” and “gap analysis” become increasingly important as they define the scope of the retirement-funding liability.
The transition from accumulator to pre-retiree and retiree can result in changes to the composition of the client’s portfolio and how it is managed, depending on the funding required and the assets available. This can, depending on circumstances, result in a transition to a range of different investment products or portfolio management strategies.
Other advice options that can have a positive effect on management of longevity risk are:
• Reducing the funding burden by delaying the initiation of the pension;
• Releasing additional capital through accommodation downsizing;
• Improving quality of life through achieving better health; and
• Maximising Centrelink benefits. The capitalised value of the Government’s Age Pension is often significantly more than client account balances.
None of this is a revelation, but in concert these strategies can have a material effect on mitigating longevity risk and improving quality of life.
Strategy options
Investment advice options for retirees will be dictated largely by their account balance. For clients with low balances, the strategy may be as simple as maximising Centrelink and pension entitlements and allocating to an annuity or term product, because there is insufficient capital to allow for assumption of any investment risk. An investor may prefer the certainty of a specified, if lower, income amount to the risk of aiming for a higher income level, but falling short.
As account balances rise, investment options begin to open up. The primary objective is to ensure basic needs are funded for the extent of retirement. This may mean the use of an insurance-type product together with the Age Pension, with any remaining balance allocated to largely income-producing assets. As balances rise further, there is less need to ensure basic needs funding and advisers can apply more traditional portfolio construction techniques to a greater proportion of the portfolio. An optimal outcome is a high probability of achieving full self-funding from existing assets.
Regardless of what strategy and portfolio construction options are implemented, the different objectives of retirees compared with accumulators cannot be overstated. Satisfying basic income/funding needs is critical for retirees as they do not have the opportunity to earn it back. When capital to support an income stream is lost, then the income is lost, in most instances permanently.
Advisers must know their clients
While longevity risk is a significant issue in Australia, advisers have recourse to an increasing range of options and products to assist clients in meeting their retirement funding objectives. Giving high-quality investment advice to clients based on their specific resources and circumstances is critical in achieving an optimal outcome. From an advice perspective, “knowing your client” and knowing the product requirements are of paramount importance in successfully managing a client through retirement.
Jeff Mitchell is director of fund services at Standard & Poor’s – www.standardandpoors.com.au
