Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 157

Managing uncertainty in retirement

This article is a response to Jeremy Cooper’s paper on retirement calculators entitled The flaw of averages. His paper highlighted that superannuation fund calculators simplistically assume constant average annual investment returns. Cooper remarked that these deterministic calculators ‘sugar-coat’ what really happens and he foreshadowed big improvements if the calculators provided a range of outcomes to expect for investment returns.

Developments already underway

Many parts of the industry strongly agree with his argument and have already adopted this approach. SuperEd and other firms are using ‘stochastic’ modelling to provide a variety of outcomes for retirement projections for fund members and self-directed investors. These toolkits provide a personal journey through a retirement process anchored on a retirement income forecast. It integrates features to engage, educate, and advise as well as providing next steps towards implementing the resultant actions.

(‘Stochastic’ means estimating the distribution or range of possible outcomes by varying key inputs over time, while ‘deterministic’ means the final outcome is fixed by the initial inputs).

Instead of a fund member being presented with a single expected capital balance at retirement, the member is provided with a range of balances including very likely, most likely and unlikely to achieve. These terms correspond with varying confidence intervals such as 95% for very likely, 5% for unlikely and between 75% and 25% for most likely outcomes. These are generated from a distribution of 1,000+ simulations.

The approach also converts those projected balances into annual income values, rather than capital balances, and provides a range of income outcomes for a member’s personal circumstances. These income answers are available to members both including and excluding the age pension. Providing individual members with tools like this is critical to helping them understand the range of outcomes so that they can plan around these uncertainties in the retirement phase of life.

Risks to navigate in retirement

Unfortunately, the defined contribution system of superannuation burdens individual members with a number of substantial retirement risks to navigate - risks that the average member is ill equipped to bear.  These include the risk of running out of money (longevity risk); the risk of investment loss (sequencing risk); the risk that markets do not produce the income they require (investment risk); the risk that their income does not keep up with their lifestyle costs (inflation risk); and the risk of continued governmental interference in superannuation legislation (legislative risk).

Whilst legislative risk cannot be managed, the rest can be mitigated or planned for by providing members with the tools to allow them to vary their run-out age (death), their level of contributions and the level of investment risk assumed (proxied initially by their current superannuation investment option risk).

Consider the example of Etta, a 51-year-old female earning $70,000 with a current super balance of $300,000 investing in a balanced fund. Etta is projected to achieve a most likely income ranging between $40,700 and $48,600 including the age pension. She is almost certain to achieve an income of $36,600 whilst she is unlikely to achieve a retirement income of $61,100 or above. According to ASFA, this should provide a level of income for a single person either approaching or above their ‘comfortable’ retirement standard. Note that this is only because the age pension comprises a substantial component of the income in retirement.

Reactions to the range of outcomes

Good communication of this approach is essential to success. Our feedback shows that the use of a stochastic range of income forecasts equips members to plan for this eventual uncertainty. That said, there are different reactions from the average super member to seeing the range of outcomes demonstrated for the first time.

A common concern comes from members who do not appreciate that their retirement income even has a possible range of outcomes. Some members view their super balance as a savings account with minimal risk and do not recognise their balance can go down. The shock experienced during the GFC was typical of the way many people interpret their super account, and showing members a range of outcomes as early as possible reveals the variability of their retirement forecast. The use of deterministic calculators - with their straight line projections – reinforce the incorrect interpretation of a savings account. It also fails to grasp an opportunity to educate members.

Other members appreciate the volatility of their balance but have difficulty translating a projected capital sum into an income in retirement. This is perfectly understandable given the complexity of the calculations involved and the lack of financial literacy. For people who have not been trained in the intricacies of compound interest and longevity modelling, projecting retirement income must be as difficult as being expected to complete your own dentistry.

Behavioural work highlights this is particularly difficult when the sum involved is large. Faced with a super balance which hopefully grows to multiples of a member’s income, many members have no idea how to switch to an income measure from such a large sum. It is common for a member to believe that Etta’s estimated income of between $40,700 and $48,600 is achieved entirely from her own super balance of $300,000.

In fact, a simple averaging of this $300,000 sum over the around 23 years to average life expectancy from age 65, with no growth, would yield a yearly income of only $13,100 per annum. The difference in the most likely forecasts comes from two components: real growth in the assets over time and the significant value of the age pension that Etta is assumed to receive.

The single age pension of $874 per fortnight (or $22,700 per annum) which grows at a 2.5% assumed inflation rate is equivalent to a present day lump sum for Etta of $516,000 (discounted at the 3% long bond rate). It is obviously worth more if she lives longer. This value is more than 1.7 times larger than her own superannuation account balance and, indeed, dominates the calculation for many super members with few assets outside of superannuation. It means that, together with the age pension, she effectively has a pension account balance to invest now of around $816,000. The remainder of the income comes from growing the assets over inflation during the period to her chosen run-out age.

Importance of age pension for most people

No wonder Etta can’t easily estimate her income range in retirement. Much of this does not yet exist in her own balance and will accumulate over time. Plus, the significant value of the age pension dominates most people’s current super balance. Of course, if Etta does not receive the age pension – for example, due to her not passing the income or the asset test, or changes in legislation - then her income in retirement will be significantly revised down.

In our experience members need to be walked through these concepts using educative content and examples to cement their understanding and also integrate retirement planning tools with both telephone and face-to-face advice. The earlier in the journey that these tools are provided, the better off we believe members will be. The 5 P’s: 'Perfect preparation prevents poor performance' is a great premise on which to base a retirement education campaign.

Members need engagement, context and educational tools to assist them to manage this complex journey to and through retirement. Over time we hope that most superannuation funds will switch to stochastic calculators which better explain the variability of outcomes.

 

Bev Durston is Head of Investments at SuperEd, a retirement income solutions provider, and founder of Edgehaven Pty Ltd, a consultancy for long term, institutional investors. This article is general information and does not consider the specific circumstances of any individual.

3 Comments
Ramani
May 29, 2016

Guiding individual savers through potential outcomes that depend on a range of factors, controllable and otherwise, will not only facilitate greater engagement, it is imperative in our compulsory, concessional and preserved system. Our super system is akin to a prison where the state holding them captive owes them, relative to free citizens, a duty of care in security and basic sustenance: except that the prisoners have been herded in due to state power.

Apart from legislative risk, personal mortality / morbidity factors and broader economic factors are what people cannot control but must react to.

One little pushed mitigant in navigating the unknowns is expectation management, including reliance on non-super and family support, and drawing down potential bequests. Given longevity, fiscal deficits and the unfunded nature of age pensions, reliance on it must realistically be reserved (and justified) only for the lowest fringe.

Bev Durston
May 28, 2016

Hi Alex,
Yes legislative risk was highlighted in the article as of particular concern. We can't model for future (nor retrospective) govt policy. I agree with you that the pressure on budgets means that this will be a moving target, which the latest budget highlighted. It is possible to model for known unknowns but not for unknown unknowns.
The Healthcare costs form part of the budgeting exercise that people have to work through as part of the income forecasting journey. This will become more important in the future and will, I expect, become a separate topic to navigate in order to estimate expected costs.

Alex
May 27, 2016

Emphasises the importance of the age pension for the majority of people, but modelling relies on current pension policy. I expect in years to come the social security bill will face incredible pressure. We will have a massive blow out in deficits, an ageing population, rising health bills, fewer workers, need for infrastructure ... something has to give. Suggest your model has a stochastic variable for age pension and health care costs.

 

Leave a Comment:

     

RELATED ARTICLES

Risk in retirement: five strategies for finding the right balance

There’s a lot more to retirement incomes than super

Richard Thaler: Nobel economist changing our behaviour

banner

Most viewed in recent weeks

Noel's share winners and loser plus budget reality check

Among the share success stories is a poor personal experience as Telstra's service needs improving. Plus why the new budget announcements on downsizing and buying a home don't deserve the super hype.

Grantham interview on the coming day of reckoning

Jeremy Grantham has seen it all before, with bubbles every 15 years or so. The higher you go, the longer and greater the fall. You can have a high-priced asset or a high-yielding asset, but not both at the same time.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

BHP v Rio v Fortescue: it's all about the iron ore price

Don’t look at an earnings forecast or a DCF valuation or a broker target price for a mining company. Share price forecasts are only as good as the commodity price assumptions they are based on, and they are a guess.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Latest Updates

Superannuation

Jane Hume shakes up super, but what will it achieve?

The Government calls 'Your Future, Your Super' the most significant reforms since the start of compulsory super. Stapling has benefits and we should remove poor funds, but performance comparisons are difficult.

Superannuation

Launch of the 'Wealth of Experience' podcast

Welcome to the first episode of our fortnightly podcast, Wealth of Experience, with Graham Hand and Peter Warnes. They have a combined 99 years in markets and they will share this experience to help build your wealth.

Investment strategies

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Investment strategies

Where will investment returns come from in 2021?

There are only three sources of returns when investing in companies. Whether an investment delivers on dividends, earnings or valuation expansion determines performance, and the contribution of each varies over time.

Investment strategies

Portfolio composition and what you find under the bonnet

Powerful structural themes such as technology disruption and demographic changes may disguise what is driving company success. Watch these broad categories as they may not apply in ways you expect.

Investment strategies

When rates rise, it's time to look for new players on the team

Long duration assets such as government bonds and property have benefitted from falling interest rates, but a turn is coming. It's time to find assets that may benefit from rising rates, such as private debt.

Investment strategies

How are high net worths investing and thinking now?

Citi research delves into how high net worth investors are feeling in the current market, and how they are investing during the drama of the pandemic. There is plenty of optimism and a willingness to stay invested.

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.