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Principles and rules to guide retirement strategies

with Adam Butt and Gaurav Khemka

Managing assets during retirement requires a plan for both investing those assets and drawing down on them. Research by both ourselves (found here) and others has modelled ‘optimal’ drawdown and investment strategies for individuals with differing objectives, preferences and circumstances.

We have extracted some principles and decision rules from this research to assist in identifying appropriate retirement strategies. This article presents the highlights with the full note found here.

Retirement objectives might be characterised into these groups:

1. Whether there is a minimum acceptable income level that an individual can’t afford to fall below.

2. The type of income they want to draw, with two alternatives:

(a) Target income level (say an ASFA Standard or income replacement)

(b) Maximise the income extracted from the assets.

3. Any bequest motive.

These objectives point toward the broad strategy, with the application moderated by risk tolerance. Our reference point is all assets available to fund retirement, perhaps after hiving off some precautionary savings, with the age pension forming part of the mix.

Minimum acceptable income

This relates to poverty avoidance and is tied to risk capacity rather than risk tolerance. If falling below some income level leaves a retiree destitute, any chance of this occurring should be eliminated if possible.

Principle – Secure any minimum acceptable income, if possible.

Decision rule – Purchase sufficient annuities to secure the minimum, accounting for other available income.

Two situations may negate the rule of purchasing annuities to secure the minimum. First is where there is virtually zero likelihood of falling below the minimum, e.g. available assets are more than ample, or the age pension suffices. Second, when available assets are insufficient to buy the required annuity, a choice arises between taking on market risk in a bid to reach the minimum if possible or buying annuities to lock in at least some income.

(Comments on annuities: These are defensive assets that facilitate securing some income for life. There is currently a concentration of providers, but reasonable demand should see more life insurance companies step up, leading to greater demand and better pricing. The value proposition relates to longevity insurance derived from pooling of mortality risk: annuities might be viewed as fixed income-like assets with longevity insurance attached. It is hard for individuals to unpack these features, but they might be able to determine if they need to guarantee some income for life, noting that no other investment products offer this attribute).

Income target

We initially convey and explain the principle that emerges, before moving to the decision rules.

Principle – Invest with the aim of delivering the income target for as long as possible using a combination of annuities, growth and defensive assets. Then draw a sufficient amount to deliver the income target, until available assets are exhausted.

When assets are so low that the target cannot be secured with annuities, it is better to invest in growth assets to maximise the chances of attaining the target for longer, notwithstanding the risk of running out if returns are poor. Once assets are sufficient, enough annuities are purchased to secure the target. As assets increase beyond this point, surplus funds are allocated to growth assets to pursue additional income (or bequests), confident that the target is secure.

Our modelling reveals a tendency for (inflation-adjusted) annuities to crowd out defensive assets such as fixed income, as they facilitate securing the target for life (assuming the provider is still around). Allocation to annuities depends on the desire to lock-in income, and often modest at around 10%-30%. Deferred life annuities tend to be favoured, with income supported in the interim by drawing on other available assets. This strategy provides longevity insurance at a modest cost, and offers potential for upside if returns are high. We also recognise that not everyone is comfortable with high growth asset exposure, so suggest setting it as high as can be tolerated.

This strategy provides longevity insurance at a modest cost and offers potential for upside if returns are high. We also recognise that not everyone is comfortable with high growth asset exposure, so suggest setting it as high as can be tolerated.

The drawdown principle implies drawing enough to reach the target after accounting for other income sources such as the age pension and any annuities, subject to the minimum drawdown rules. Once available assets are exhausted, income then declines to that arising from these other sources.

As an example, if the income target is $30,000 and other income sources deliver $24,500, then $5,500 is drawn until assets are exhausted. One reason behind this strategy is that, while drawing a below-target amount extends the timeframe over which the assets last, the probability that the income will never be enjoyed rises due to being less likely to be alive later in retirement. ‘Better spend it while you can.’

Decision rules:

  1. Establish the annuity purchases required to secure the target income for life, allowing for the Age Pension and other income sources.
  2. Purchase the required annuities, subject to not exceeding some upper limit of available assets. We suggest a 60% upper limit on annuity purchases to retain some access to capital and flexibility.
  3. Where available assets are insufficient, scale back annuities to guarantee any minimum acceptable income.
  4. Invest remaining amount in growth assets, as far as can be tolerated.

Maximising income

Some individuals may wish to extract as much income as possible out of their assets, while managing the risk of income falling to undesirably low levels. This requires balancing the potential consequences of drawing too much earlier and/or poor investment returns, against not drawing enough and dying with large residual assets. (We agree with the Retirement Income Review that the goal should be converting assets to income, rather than spending investment income only and keeping the pot.)

In trading off these elements, the modelling generates time-varying drawdowns and investment strategies that mainly combine growth assets with annuities. Annuities are directed at smoothing and limiting the downside to income; and tend to crowd out other defensive assets.

Principle – The drawdown and investment strategy should be jointly directed at converting assets into as much income as possible, while leaving behind no more assets than intended.

Decision rules:

  1. Determine how much income to protect using annuities. Decide the income to protect (in excess of the minimum), allowing for other income sources such as the age pension. This depends on risk tolerance, but we suggest an upper limit of 60%.
  2. Invest remainder in growth assets, as far as can be tolerated.
  3. Establish an affordable drawdown strategy. The ‘affordable’ drawdown assets remaining after annuity purchases is estimated and initially drawn. One approach is calculating the real drawdown amount that can be sustained to a certain age under the selected asset mix. (Our estimates suggest it might be something like 8% of initial assets.)
  4. Review the drawdown strategy occasionally – The drawdown strategy is reviewed occasionally, including re-estimating the affordable drawdown.

The Actuaries Institute has proposed a rule for varying drawdowns with age and balance that might be surrogate for rules 3 and 4 above (found here).

Bequests

Adding a strong desire to leave a bequest to our models leads to substantial reductions in drawdowns, lower annuity purchases and greater growth asset exposure.

Principle – A strong bequest motive implies restricting drawdowns to tolerable levels and directing the investment strategy towards building assets.

Decision rules:

  1. Use annuities only as far as required to secure any minimum acceptable income.
  2. Drawdown only what is needed.
  3. Invest in growth assets, as far as can be tolerated.

Risk tolerance

Risk tolerance moderates how the principles and rules are applied, with higher risk tolerance associated with lesser use of annuities, greater growth asset exposure, more volatile drawdowns, and increased willingness to accept the possibility of lower income.

Principle – An individual with high risk tolerance should reduce annuity use in favour of additional growth assets and use the opportunity to increase their expected income (or bequest).

Under high risk tolerance, annuity purchases might be restricted to securing any minimal acceptable income, with drawdowns initially increased in line with the higher affordable drawdown.

While individuals should benefit from higher growth exposure, we add this principle to accommodate those with limited appetite for asset volatility over shorter periods:

Principle – Set growth asset exposure at the maximum that can be tolerated.

The growth asset weight might be set by (say) placing an x% probability limit of -y% loss over 1, 2 or 3 years. Alternatively, a bucketing strategy could be used to help individuals deal with short-term market fluctuations.

Final thoughts

The principles and rules do not in themselves deliver the specifics of strategies: we leave this for product designers and financial advisers. Nevertheless, they indicate the broad type of strategy that suit particular objectives and risk tolerance. We realise that we suggest some of the strategies are at odds with observed behaviours such as anchoring on minimum drawdown rules and widespread use of fixed income rather than annuities for defensive exposure. We offer them as a way of improving on existing practices, noting they are rooted in rigorous modelling.

 

Adam Butt is an Associate Professor and Head of Actuarial Studies, Gaurav Khemka is a Senior Lecturer and Geoff Warren is an Associate Professor and Fund Convenor, ANU Student Managed Fund at the College of Business and Economics at The Australian National University.

 

5 Comments
Dudley.
February 22, 2021

Using:
https://www.abs.gov.au/statistics/people/population/life-tables/latest-release
what formula do actuaries use to calculate the owner-age discount factor?

The time discount factor is:
1 / ((1 + r) ^ t)
where:
r = discount rate, t = time.

Ian
February 18, 2021

Who knows if the companies providing annuities will still exist in 20 years time? Combine this with low returns and the big question is who will use annuities.

Geoff Warren
February 18, 2021

Hi Ian,
Agreed that what happens to the annuity provider is certainly an issue to consider, albeit something to consider in nearly any Investment! I will offer a different slant on the annuities offer low returns. In line with the comment by ‘CIPR sceptic’, all investments seem to be pricing for low returns at present, include risk assets like equities. We find that if we drop the returns across everything in our modelling (annuities, fixed income and equities), that annuities still feature similarly. It is the longevity insurance that distinguishes them. Lower returns mean lower potential income can probably be drawn over the long run. It is an inconvenient truth.

Rod Apel
February 18, 2021

The general nature of the guidelines are very useful. Many thanks. Rod Apel.

CIPR sceptic
February 18, 2021

Yes but the effective rates are lousy on annuities, and the entire industry is struggling with these CIPRs which everyone is supposed to offer but nobody can design. The FSI recommended them in 2014 and nothing has happened since. There's a reason for that - there's no silver bullet to disguise the fact that government bond rates are 1% and everything else has a risk.

 

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