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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.

 

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