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What financial risks do retirees face?

The recently completed Treasury consultation into the retirement phase of superannuation is making waves in retirement income circles, as a result of the wide range of issues for which views were sought, and the divergent responses in submissions made public so far.

A particular focus of the consultation was on how APRA-regulated super funds are delivering on their obligations under the Retirement Income Covenant (RIC). This requires fund trustees, from 1 July 2022 onwards, to formulate, record, implement, make available and regularly review a retirement income strategy to assist their members in balancing three objectives in retirement, these being:

  • to maximise member expected retirement income;
  • to manage expected risks to the sustainability and stability of member retirement income; and
  • for members to have flexible access to expected funds during retirement.

The RIC identifies three specific risks to retirement income that trustees must consider: longevity risks, investment risks and inflation risks. In addition, trustees must have regard to “any other risks to the sustainability and stability of retirement income”.

What exactly might these risks be? In my submission to the consultation, I included an appendix with a list of the key financial risks to an individual’s standard of living in retirement. The following is an exposition of these risks, taken from my submission (with additional detail where needed for context), and presented in alphabetical order.

Budgetary risk

Expenditure patterns can vary considerably during the active (broadly one’s 60s to early 70s), passive (early 70s to early 80s) and frail (early 80s onwards) stages of retirement. As individuals might move through these stages differently, budgeting for expenditure needed across an entire retirement is a considerable challenge.

This challenge is further complicated by health issues that tend to be correlated with the ageing process, such as dementia. Some of the precautionary savings behaviour exhibited by retirees may be a measure of self-insurance against health care costs associated with such potential advanced aged concerns.

Counterparty risk

Most financial products involve an exchange of money by one party for a set of financial claims on another party (typically a financial entity). The nature of the claim might be as simple as interest, in the case of a basic savings account, or as complex as margining requirements for derivatives such as futures.

In each case there is counterparty risk; the risk that the party you, the investor, are relying on to deliver on your financial claims, possibly decades into the future, is unable to do so as and when required. Whilst strong prudential regulation can mitigate counterparty risk, it can never fully remove it.

Inflation risk

Expenditure in retirement is subject to inflation in broadly the same way it is prior to retirement, although the composition of retiree consumption baskets may differ depending on household type.

Any increase in the retirement cost of living, if not accompanied by an equivalent increase in cashflow, results in a loss of purchasing power and thus a decline in one’s retirement standard of living.

Investment risk

During the accumulation years, members don’t know what their final retirement benefit will be, subject as it is to the vagaries of financial markets, over which neither an individual member nor their super fund exerts any control.

Things are no less complicated once in retirement, with investment returns playing an outsized part in maintaining purchasing power in retirement, where account-based pensions with exposure to growth assets are used. Negative investment returns can, despite the ameliorating effect of diversification, accelerate capital depletion, thus impacting one’s living standard in retirement.

Legislative risk

A member’s retirement may span two or more decades, during which time it is possible that legislative changes may occur that negatively alter one’s financial outcomes.

Whilst some disadvantageous changes may be ‘grandfathered’ and their impact thus mitigated, legislative risk still represents a long-term risk to retirees.

The proposed measure to apply a new 15% tax on earnings to individuals with total superannuation balances in excess of $3 million dollars (currently being reviewed by the Senate Economics Legislation Committee) is a clear and present example of legislative risk.

Liquidity risk

Retirees may require rapid access to lump sums of capital at short notice to meet unplanned expenditure. Liquidity risk arises where there is a mismatch between the assets backing a retiree’s pension product and the ability to redeem it for cash, at short notice, with no discernible impact on value.

While liquidity risk is considered as part of the third RIC objective for members of APRA-regulated funds, this risk within SMSFs in pension phase requires careful management, particularly where large illiquid assets, such as real property, make up a non-trivial component of a retired member’s benefit.

Longevity risk

Longevity risk can be thought of as the risk of living beyond actuarial life expectancy, and in so doing exhausting one’s private financial resources before death, consequently experiencing a fall in living standards below that which is then desired.

It is important to make the distinction between private financial resources and those that might be accessible via social security; specifically, the longevity risk hedge of the Age Pension, payable as it is for life (subject to meeting the qualifying criteria and thereafter the assets and incomes tests).

Longevity risk complicates the budgetary process, often resulting in members drawing the minimum prescribed pension amount (where an account-based pension is used) to self-insure against prematurely exhausting their capital base.

As a result, the consultation explored a number of options to help trustees mitigate longevity risk for identified groups of retirees who may be subject to it, including through the use of lifetime income products where appropriate.

Management & agency risk

When deciding on a super fund (or an investment option therein) an individual cannot know whether their selected fund will thereafter perform well relative to its peers and investment objectives. In a sense a super fund’s offering can be viewed as a bundle of promises about the future with no guarantees attached, the veracity of which cannot be confirmed before the fact.

This risk arises as trust placed in the competent stewardship of retirement savings with a super fund (or an adviser) may not be repaid, either through poor management, a misalignment of interests or ineffectual governance.

Issues that produce sub-optimal results in the accumulation phase are exacerbated in retirement, where every dollar lost to agency risk is one less dollar of retirement income.

Sequencing risk

Where an account-based pension has exposure to investment risk, a member’s account balance (and by extension, pension income) is ‘path dependent’ on the sequence of returns achieved by the investment strategy, particularly at and into the early years of retirement.

A poor early sequence of returns in an account-based pension can accelerate capital exhaustion faster than might have been expected. Sequencing risk is a function of investment volatility, which in retirement creates a tension between the desire for high investment returns (to help manage inflation risk) on the one hand, and the desire to avoid being forced to sell into a falling market, just to make pension payments, on the other.

 

Harry Chemay has over 26 years of experience in both wealth management and institutional asset consulting. Initially a private client adviser with an SMSF focus, he has since consulted across wealth management, FinTech and superannuation, with a focus on improving post-retirement outcomes. Harry was also a co-founder of the online investment platform, Clover.com.au, subsequently acquired by wealthtech entity SuperEd.

 

4 Comments
Denial
March 26, 2024

It is not rational for most to draw down at anything but min. There is a significant financial and liquidity cost in protecting against longevity. Very few will benefit from it in fact other than in a theoretical exercise. What is also interesting in the distribution of balances at retirement. Mean averages are deceiving given the vast majority will continue to retire with sub $250K balances for the foreseeable future.

Eric
February 29, 2024

Excellent summary Harry. It’s all very well the Government and others complaining that many retirees are not fully expending their retirement savings but, as your submission rightly highlights, retirees face many unknowns not least of which is future health and care needs in old age. If retirees fully spend up and run out of money, who will support later health and care needs? The Government can’t afford the inadequate health and care support needs of older Australians as it is, and the demand is going to grow significantly! As usual, governments want their cake and be able to eat it too. By all means, deliver improved options for retirees to access their funds in flexible ways but choice needs to be retained.

PaulB
February 29, 2024

Well said Harry and Eric. The government and some columnists consistly bleat on about retirees being frugal with their super drawdowns but never show consideration for potential health risks as mentioned above. If one ever had to place their partner into care, the financial burden would also be horrendous.

Mark
February 29, 2024

Good summary Harry

 

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