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Retirement myths doing more harm than good

Australia’s superannuation industry is obsessed with accumulating account balances. The industry has confused or complicated the primary purpose of providing for retirement by fostering the following claims:

  1. Members need much more financial literacy
  2. The 4% withdrawal rule is (or isn’t) safe
  3. Retirees suddenly run out of money
  4. Sequencing risk is a real issue
  5. Retirees need a new breed of investment products

We argue that changing the focus of superannuation to retirement outcomes is essential, and will make superannuation meaningful to members. In doing so, we need to retain critical thinking.

Some of these claims do not seem to stack up, but are they myths?

1.  More financial literacy

The industry is a victim of its own design. It is obsessed with account balances and what happened over the past year. What does this babble have to do with retirement outcomes?

How many superannuation practitioners can translate a member’s account balance and future contributions to what the member may receive in retirement? Very few, as the calculations are complex. If we find it hard, no wonder members don’t understand superannuation.

In the defined benefit days, members were simply informed of retirement outcomes. If this was re-introduced as a simple statement for defined contribution members such as,

“Your superannuation account and future contributions have a good chance of delivering $1,000 per week when you retire.”

… then we are expressing the outcome of superannuation in language that most members should understand, their pay cheque.

Result: Myth busted.

2.  The 4% withdrawal rule

The often quoted Trinity Studies found 4% of the initial account balance at retirement could be safely withdrawn each year, inflating annually thereafter. Critically, this analysis incorporated the impact of investment volatility to arrive at a safe withdrawal rate.

But to our knowledge, no fund in Australia informs members of their safe withdrawal rate. Worse, some funds provide estimates that ignore investment volatility. Even ASIC’s methodology under Class Order 11-1227 (see ASIC’s Consultation Paper 203) has been found to be simplistic and misleading.

Using our retirement income calculation engine with moderately conservative investment assumptions (such as ignoring valuation reversions), we found that in many cases, the 4% rate (ignoring ATO allocated pension minimums) is safely funded from a typical balanced strategy. The ‘4%’ rule of thumb is not bad, but each member’s circumstances are different. Retirees shouldn’t be relying on rules of thumb.

Result: A controversial myth which needs context.

3.  Retirees suddenly run out of money

Do they? How often have you seen a chart like this?

PV CC Chart1 120914

PV CC Chart1 120914

The authors of such charts are incredibly patronising. They assume that retirees do not adjust behaviour in light of changing circumstances. Of course, if you don’t watch the road when driving a car, then you are likely to crash. The same applies to retirement account balances, they need to be monitored and withdrawals managed.

But it is true that retirees have inadequate tools to help them stay on the road.

Better controls are available. For example, the following chart shows the three-way trade-off between the level of withdrawals, the age that they are likely to last and the impact of investment risk.

PV CC Chart2 120914Provision of information extracted from this chart can form the basis of a retirement monitoring and management ‘control panel’ assisting retirees to manage the changing requirements through retirement.

Result: Myth busted.

4.  Sequencing risk

This is the risk that the worst returns at the wrong time will greatly impact a member’s retirement outcomes. A paper by Drew and Walk identifies a ‘retirement risk zone’ as approximately 20 years around the retirement date.

We believe the following points put sequencing risk in context:

  • The age pension buffer

The income and assets tests of the age pension make it an excellent hedging instrument for the risks of an eligible retiree’s investment portfolio. Falls in asset values and withdrawals will result in an increase in the age pension. Hence the age pension provides some hedging of the impact of sequencing risk for those receiving a partial age pension.

  • Asset valuations revert

Valuation measures (e.g. PE ratios) tend to revert to the mean over the medium term (7-10 years). Whether you enjoy or suffer from this reversion will depend upon (a) your pace of saving or dissaving, and (b) changes to investment strategy. This is real, but the impact is idiosyncratic. Much hand waving about sequencing risk ignores this reality and can result in inappropriate scaremongering and poor investment decisions.

  • Through retirement, not to

Obsession with account balances leads many to make dramatic changes in investment strategy at retirement, such as selling equities to purchase a fixed rate income stream. This creates unnecessary sequencing risk. It runs the risk of a double hit: selling equities after a crash and buying bonds when interest rates are low. On the other hand, if the retiree is managing THROUGH retirement, then this self-generated sequencing risk is avoided, and the benefits of mean reversion can be enjoyed.

  • Manage with feedback

Prompt, relevant and objective feedback is the best way to learn about anything. With the tools discussed earlier, a retiree can understand the consequences of their investment and drawdown decisions. If this is provided regularly in terms they understand (i.e. future sustainable retirement ‘pay cheque’), then they will make sound decisions. Imagine the peace of mind that retirees would derive from seeing that their projections of safe retirement rates have not moved much in times of market volatility.

Result: Put myth in context.

5.  Need for new retirement investment products

It is not surprising that financial service providers are touting new retirement investment products: this is how much of their revenue is derived.

But, as is evident from our earlier comments, we believe that the key missing component is useful information in a language that retirees understand. Indeed, most superannuation funds already have a comprehensive range of diversified investment options. This range will often be sufficient (perhaps with some tweak for tax etc), provided retirees can assess each investment option in terms of safe withdrawal rates.

So do retirement products such as lifetime annuities have a place? Yes, but not as much as you might think.

Members with low account balances at retirement already have a significant lifetime indexed annuity from the Government. And members with substantial balances can live off dividends and income. In between, members can obtain financial flexibility and longevity through a retirement ‘control panel’. Sure, lifetime annuities and deferred annuities may play a partial role, but they are not the total answer. And they can be expensive and inflexible.

Result: Myth busted.

Conclusion

Myths and confusion have been perpetuated by the industry’s focus on the journey through the accumulation phase, together with a lack of understanding or use of the impact of investment volatility. The industry must communicate with members in the language they understand, i.e. their sustainable retirement ‘pay cheque’. Providing retirees with a ‘control panel’ that they understand will stop them driving off the road (i.e. running out of money) thus empowering them with the right information to make sensible decisions.

 

Chris Condon and Peter Vann have been in the institutional investment industry for over 25 years. CV Solutions, a partnership between Chris Condon Financial Services Pty Ltd and Peter Vann, provides retirement adequacy services to superannuation funds.

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13 Comments

Chris Condon

September 19, 2014

Tim,

We agree that it is dangerous forecasting account balances. Indeed, it is our view that the current emphasis on account balance disclosure by funds and regulators does a huge disservice to members… It distracts them from the primary purpose of superannuation, which is about funding a stream of income in retirement.

However we believe that forecasting retirement incomes with various likelihoods provides useful information in the member’s own language.

Tim

September 17, 2014

RE: Myth #1.

No trustee in their right mind would give account balance forecasts...particularly stretching 40 years into the future. Its a guarantee of multi-billion dollar class actions in the future.

What rate of return do you assume for a 'balanced' investor? 4%, 6%, 8%

Matthew

September 17, 2014

I don't think Myth # 1 was "busted" at all. The minute you start putting dollar figures to a retirement "pay cheque" you are creating expectations that may or may not be met. That is the whole point of accumulation versus defined benefit funds. Just ask anyone who retired at or around the GFC (many of whom are now "un-retired").

Also, the article assumes the Age pension will always and forever be around to act as a buffer. I very much doubt this will be the case.

Frank Macindoe

September 16, 2014

The difficulty is of course that the simplicity that used to be available under the old defined benefit schemes is simply no longer available to most Australians, who now have to take the investment risk that used to be borne by their employers. Any time that you are making forecasts, some uncertainty is inevitable and dealing with it takes some judgement.

I certainly agree with their point that “sequencing risk” can be overstated, particularly where the retiree can live within the income that the portfolio is producing and they make the very good point that it should always be a dynamic process, with investors adjusting their strategy from time to time rather than thinking they can set and forget.

Ramani

September 16, 2014

Myths, like mould, grow and proliferate in conducive conditions. Fear of the unknown and unknowable, extrapolation and self-interest help.
While the article clears some cobwebs, they will recur without care.
An urgent first step is to remove the ability to use retirement savings as an estate planning device in a regime free of wealth, gift or inheritance taxes. Tax encouragement for one's retirement is justified, but grandkids' uni fees is not.
Best to let the sunlight of reason penetrate mouldy corners.

Mark

September 15, 2014

Great article.

David

September 14, 2014

I like your second figure in section 3.

One reason I'm concerned about sequencing risk is that first figure in section 3. Most Australian financial planners still seem to use a fixed rate of return (often approximately the historical average/target for a given asset allocation) rather than thinking in terms of probabilities.

This means that in the cases where the timing of returns combined with planned drawdown provide a worse case than assumed, sequencing risk can be realised. Sure, as you note, a retiree can cut back, etc. But it just shows the inadequacy of an average annual growth rate as a planning tool.

Peter Vann

September 13, 2014

D Ramsay
Yes, your first two questions are very much on track, i.e. the vertical axes shows the retirement income per annum** that can be drawn from an account based pension (supplemented with a partial age pension in this case) to a specified age and the colours indicate the level of certainty that the income will last to that age. Green is the safest and red unlikely.
The example we used shows there is a good chance of obtaining $37,800 p.a. to age 91, and you can read from the chart that there is a high chance of obtaining $32,000 to age 91 and a low chance of obtaining $45,000 p.a. The uncertainty is due to investment volatility.
We see this as an initial assessment of the likelihood of achieving various retirement income levels. Then one can explore various adjustments such as (a) funding higher expenditure levels in the early active retirement years, or (b) the impact on future annual income from taking a lump sum at a specified age in retirement, etc etc.
We believe that the information in this chart can be useful for assessing the adequacy of one’s superannuation account at any age through the accumulation phase and then during retirement it assists with retirement income budgeting, but that is another topic not explored in the above article.
Hope that helps.
Peter
** expressed in today’s dollars, hence in reality the numbers increase each year with inflation.

D Ramsay

September 13, 2014

I think the graph in Point 3 needs clarification/explaining please. What is the graph's vertical axis showing ? Is it showing $ amounts that may be withdrawn from the super fund per annum ? Or is it showing annual income generated by the superfund and the curved lines show what a 4% per annum withdrawal rate would to the fund in terms of the probability of it running dry of funds ?

Thank you

PJ

September 12, 2014

Myth 7: Loading up on volatile growth assets will produce a stable, sustainable and reliable retirement income.

or should it be...

Myth 7: Your spending needs are just as flexible as market movements. When your growth assets fall 20 per cent you'll be easily able to cut your spending by the same amount. Bills, grocery prices and medicine will fall too!

David

September 12, 2014

Exactly PJ - the fact prices go up is exactly why, long-term, so will shares.

Anyway why does a 20% asset value fall bother a self-funded retiree? If I hold 100 CBA shares I'm still receiving 100 dividend payments - and in my experience one thing company boards don't like doing is cutting dividends.

You stick your retirement funds under the mattress, I'll stick with Aussie shares and enjoy the 8th wonder of the world funding my retirement - the franked dividend.

David

September 12, 2014

Myth 6. At retirement you reduce exposure to growth assets.

Paul Watson

September 12, 2014

Excellent article and great comment from David.
Just because you "retire" doesn't mean your money has to "retire".


 

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