Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 167

Deriving an effective retirement income

Superannuation funds are becoming increasingly aware that what members really want is income certainty in their retirement as opposed to just aiming for wealth maximisation and a net worth figure.

The Federal Government wants to enshrine the objective of superannuation in law, as part of its response to the Financial System Inquiry. The Government accepts that the objective is to provide retirement income to substitute or supplement the age pension. That means superannuation fund managers will need to change the way they currently think about risk management and the options they currently offer their members.

Nobel Laureate Robert Merton

American economist Robert Merton, who was in Australia recently to discuss retirement income strategies, is an acknowledged world leader on the subject of retirement incomes. Currently the Resident Scientist at Dimensional Funds Advisers, he is also a Professor at both the MIT Sloan School of Management and Harvard University, and he was awarded the Noble Prize for Economic Sciences in 1997 for developing a method for determining derivatives values.

Merton’s research has more recently focused on lifecycle investing, retirement finance and optimal portfolio selection. In an article written for the Harvard Business Review called ‘The Crisis in Retirement Planning’, he argued that a good retirement investment portfolio had to prioritise income-generating ability over any supposed value. “Asset values and asset volatility are simply the wrong measures to use if you want to derive a sustainable income in your retirement,” Merton said.

Superannuation funds must be mindful when building their portfolios that members will need their money for income regardless of what happens to inflation, stock markets and interest rates, something they may not have prioritised in their investment thinking and planning sufficiently before.

In Australia, the Federal Government has agreed to remove some impediments to retirement income products and for funds to publish income projections on members’ statements. However, these projections can vary wildly and the information has to be meaningful for it to be of much use to investors.

This is where considerations of inflation and interest rates become essential, Merton argues. “Risk-free annuities need to be viewed from an income-generating perspective, and this needs to take inflation into account,” he said. Inflation can have a huge impact on retirement lifestyle. If, for example, inflation is running at 2% per annum over the five years before retirement, the real value of the nest egg in wealth and income terms falls 9%.

Similarly, if a customer puts $300,000 into a term deposit when interest rates were around 7% and five years later, rates have fallen to 2.5%, the interest from that deposit has been cut from $21,000 to $7,500 per annum, a massive 64% decline in income.

Super fund members should be able to see not only what they can potentially afford in retirement but what they can do to manage uncertainty. For example, if they are not on track to achieve their desired level of income, they may have to save more, work longer hours, or simply adjust their expectations if possible.

Communication and risk mitigation

Providing relevant information to investors alongside risk mitigation solutions is a powerful combination. An ideal solution, therefore, allows participants to invest toward retirement income over time while simultaneously protecting investments from market risks.

“Just about everyone who saves or invests does so to support some future consumption. We know that the key to any asset allocation is to identify the right hedging asset for a given liability,” Graham Lennon, Head of Retirement Investment Strategies and Vice President of Dimensional said in a paper called ‘Retirement: Making Income the Outcome’ in November last year.

If a fund member wants to reduce the volatility of their account balance, they can invest in assets that are stable in wealth terms. “How do we manage these risks? We can conceptualise our retirement liability as a series of equal inflation-adjusted payments from retirement to life expectancy,” Lennon said.

This future liability looks a lot like a bond, with a series of payments and a duration. By investing in a portfolio of inflation-protected instruments that match the duration of those payments, it is possible to construct a strategy that hedges interest rate and inflation risk, Lennon argues.

This involves asset allocation that effectively manages the trade-off between assets for income-growth (increasing the balance available to draw income from) and assets for income risk management. Early in the lifecycle of a member’s super fund, their focus should be on income-growth assets. Later, the focus should shift to income risk management, or what Merton describes as “duration-matched inflation-protected securities”. This focus on managing income risk should then continue for the term of the retiree’s natural life.

 

Alan Hartstein is a freelance writer and editor.

4 Comments
Randall Kingsley
August 05, 2016

Thanks for yet another interesting and thought provoking article. What I think is being missed in almost all of the debate about incomes in retirement, whether the focus is on asset size, incomes to be generated, gradual risk reduction as we age etc is that Retirement itself these days is or is becoming almost as big a period in our lives as 'work' itself.

In my view, the point at retirement is when we have made a decision that our 'wealth' is enough to replace or almost replace our 'work' incomes. So if we are to live as we would wish for around another 30 years (depending on when we take our retirement), most of us have to move from taking a weekly wage income to becoming little capitalists. Our money needs to grow from our capital investments for which we need advice and we need to be drawing an income which is a replacement for our former work incomes for which we also need advice.

So the priority should be both growth and income, considered together to cover a very considerable time. Retirement is a reflection point and not some sort of step change.

Peter Vann
August 04, 2016

Alan

Thanks for the insights from Merton. I find it interesting that quite a few systems in the USA (including to my knowledge Dimensional) forecast a distribution of retirement outcomes by annuitising the balance (itself a statistical distribution) at retirement.

In Australia, I understand that very few people annuitise at retirement. Hence a practical tool would account for the investment characteristics through retirement (as discussed in David Bells' article).

Peter

Peter Vann
August 04, 2016

Ashley
I would welcome your thoughts on what you believe can be used
1) instead of "random, log normal" distributions, and
2) to avoid being (as you say) highly simplistic.
Thanks
Peter

Ashley
August 04, 2016

Theoretical models on retirement built on stochastic (random, log-normal) distributions are highly simplistic. No market over any time frame – from nano-seconds to decades – is or has ever been random or log-normally distributed. Stochastic assumptions understate downside risk by tens of thousands of per cent (yes, I have studied these models).

It's all in the name of wealth transfer which is the free market at work. Nobel himself specifically said economics was not a discipline worthy of recognition. But economists got together and invented their own award 50 years later.

 

Leave a Comment:

     

RELATED ARTICLES

Superannuation needs greater outcomes focus

How safe is my super from rule changes?

Super performance test will destroy viability of some funds

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.