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Super funds fail clients by not reporting retirement income

Over the past 20 years, I have been managing a variety of government and industry superannuation and pension funds in Australia, Singapore and the UK. Returning to Australia last year after a seven year contract in the UK, I have noted some shortcomings in the way information about superannuation is reported to individuals.

The Australian superannuation system has an excellent reputation as one of the most successful for ensuring the majority of the workforce automatically makes some provision for their retirement. Many countries have subsequently adopted some of these features into their own systems including the UK which implemented its form of Defined Contribution (DC) pensions, known as ‘Auto-Enrolment’ in 2012.

The early adoption by Australia of a DC system more than 20 years ago was a masterstroke of strategic vision and demographic awareness. In implementing DC, it allowed the private sector, the Federal Government and the individual states and territories to largely eliminate any link of retirement incomes with workers’ final salary defined benefits (DB). According to APRA, the DB-only component of the super industry was only $70 billion as at June 2013 – a mere 4% of the asset base.

But one of the unfortunate consequences of moving to a DC system is that superannuation has become detached from any link to an income that the individual can expect in retirement.

Losing the link to salary

The original idea of a ‘final salary’ or DB pension scheme was simple for an individual to understand: the level of income in retirement would be linked to the salary they were earning whilst contributing to the scheme. There were technicalities about contribution rates, which salary (final or career average) would be paid and how overtime and other variable uplifts would be treated, but the basic notion had clarity and was easy to communicate.

In Australia, only a limited number of employers ever offered DB income streams. The market here generally had a ‘lump sum at retirement’ model which I believe is far inferior to an income stream. Contrast this with the benefit in the UK where a worker who had contributed to their pension beyond 20 years could expect to receive roughly two-thirds of their salary by way of a pension income after retirement. This income would typically be indexed to the cost of living and would last for the entire life of the worker. Whilst the provision of income in retirement was the responsibility of the employer, the individual always had a guideline for the level of income in retirement.

Under the current DC system in Australia there is no link with the projected income that a worker can expect to receive in retirement. All of the risks of achieving an adequate retirement income have been successfully passed onto the worker. These risks include, but are not limited to:

  • longevity risk - how long will the individual live and need the income
  • adequacy risk - building an adequate pool of savings to cover the income needed
  • investment risk - the investment strategy adopted for the rest of their life
  • drawdown risk - how much to draw on the pool of savings once the individual retires
  • inflation risk - how to keep pace with any rise in the cost of living in retirement
  • healthcare risk - what health care needs the individual may have in retirement
  • provision for after-death – how much to leave and how to manage this.

The responsibilities of the individual under a DC system are daunting.

The need to report projected income from superannuation

At present there is limited free advice available to individual workers to assist them with these DC risks. Some employers provide independent financial advice, and most super funds provide some level of free advice but this often focuses solely on their own funds. Most individuals are not equipped with the right information from their super funds to make the best informed decision.

Super funds should provide improved reporting to aid members to make decisions about retirement. Each individual receives an annual statement showing their current superannuation accumulation balance. What is missing is the projected retirement income (in real terms, adjusted for inflation) compared to their current salary. In the DC world, inflation risk rests with the employee, and they need to know the value of their savings in current dollars.

Behavioural finance concludes that people feel content with a much smaller accumulated total than they actually need. As soon as an accumulated balance gets close to a multiple of salary (say three times average salary at $150,000) or close to the cost of the average property in Australia (say ten times average salary at $500,000) then individuals ‘feel’ wealthy and no longer focus on saving more.

This is inappropriate because these sums will not provide - even for a worker on average salary – sufficient income in retirement to live at the same level of comfort as when they were earning their salary. The salary-linked reporting provides the right information, despite the fact that it may not be a pleasing message for most workers.

Sound assumptions are required to prevent this being used purely as a marketing exercise. Good practice would be to establish a set of assumptions (i.e. on asset growth rates, retirement age, inflation) for use by every super Fund across the industry so that the projected income number is comparable across funds.  In the UK for example, the Pension Regulatorsets the assumptions for these comparisons and each annual pension statement has to show an expected income per annum assuming growth rates of 3%, 5% and 7% of the assets until retirement.

It is very useful for a 40 year old Australian who still has time to save more for retirement to be told that their projected income will be only 15% of their current salary adjusted for inflation. They have time to take corrective action, if financially possible.

Given that contributions are related to salary it seems strange that the accumulation pot size is given so much importance. The objective of the DC saving scheme is to produce an income in retirement for individual workers.  A sceptic might suggest that super funds do not want to tell their members this vital piece of information lest they receive poor member feedback, or worse, cause members to switch to another fund. This can be addressed by using agreed industry-wide assumptions which are sanctioned by the regulator, APRA. But not giving this vital piece of information as early on as possible is letting the clients down.

Link to the employer’s remuneration policy

Another hidden corollary of the current compulsory DC system is that employers have now ‘switched off’ from using pensions as a positive tool in their remuneration policy. Before compulsory superannuation, quality employers would use higher superannuation benefits as a method of enticing quality employees to work for them and to retain the loyalty of their existing staff.

Nowadays in Australia the opposite might be true – that superannuation might actually become a negative for remuneration policy. Since it is compulsory, superannuation is not considered a variable component of remuneration policy. And the requirement for incremental increases in superannuation contributions over time may actually ‘backfire’ on employees. A worker may feel they lose out because a potential wage increase may instead be allocated towards a mandated super payment. In this way real wage cuts are likely as superannuation contributions gradually increase.

Summary

The Australian super system has set the standard for governments to reduce their reliance on social security pension provision. But the individual worker has assumed significant responsibilities for the total management of their income from retirement to grave. Most individuals are relatively unaided and without the necessary reporting tools to correctly interpret data and make decisions. I find it startling that even today, most super funds do not report to their members a projected income in retirement.

 

Bev Durston has over 25 years’ experience of implementing investment solutions for pension funds, sovereign wealth funds and fund managers. She recently relocated to Sydney and founded an advisory business for institutional clients, Edgehaven Pty Ltd. Bev has a first class Banking and International Finance degree from CASS in London, and a Masters of Applied Finance from Macquarie University.

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8 Comments

Chris Condon

May 05, 2014

I thank Bev for making these excellent points, especially the importance of changing the focus away from account balances towards retirement income estimates. After all, this is the primary purpose of superannuation.

But our regulators do not seem to get it. ASIC muddies the water, by issuing Class Order 11/1227, which implies that trustees need to use a simplistic and often misleading method of calculating a point estimate retirement income to avoid such estimates as being deemed "advice". I am advised that this implication is wrong in law. Objectively calculated retirement income estimates made with a stochastic model that takes into account investment volatility, and uses sensible assumptions, is not "advice", but a clearer presentation of the a member's facts.

And many of the recent regulatory changes exacerbate this failing. For example, the requirement to disclose details of individual investments that make up the account balance seems only to benefit the fund's competitors (and thus hurt the member). Not only this, it is another example of costly focus on the wrong thing: the account balance.

Another example is the crazy Standard Risk Measure, which again focuses on annual changes in the account balance. Indeed, this measure is so stupid that, in many cases, it will deliver perverse risk measures if risk is, instead, measured in terms of the levels of retirement income that a member has good chances of receiving. (Note, "good chance" is not the 50:50 chance that is implied by simplistic point estimates.)

Surely in the 21st Century we have the technology and computing power to incorporate investment risk in our models when it make a huge difference to our estimates.

Bev has suggested that retirement income estimates be made using standard assumptions. But let's make sure that those assumptions include investment risk, and do not just lead to more of the same misleading point estimates.

As Bev notes, Australia is a couple of decades in advance of most countries on the DC journey. We cannot look to them for answers, as they are not yet facing into the issues to the same extent. We have the smarts in this country to lead the way, and we should continue to do so.

Harry Chemay

May 06, 2014

My reading of attempts to introduce income-focused super projections is a little different. As someone who has long held the view that the dominant investment frame of our DC-centric system sends the member down a path of looking for answers to the wrong question (i.e. how much super is enough?), I too would welcome change. Asking questions in a consumption frame (i.e. how can I achieve an adequate income that can be sustained throughout my retirement years?) results in very different considerations, and quite likely choices, both prior to and in retirement.

I have been a keen follower of attempts to introduce super projections at the individual member level; particularly into annual member statements. And I have to give ASIC its due here; it was ASIC who, in 2008, led the way and put this exact issue on the table for industry discussion. Their Consultation Paper 101 of 2008 said as much: "Our view is that consumers may benefit from some form of personalised superannuation forecast, which could give them an indication of what will be available to them at retirement. We envisage that such forecasts could serve an educative purpose, helping consumers to make choices about their super savings that will assist them to achieve financial security in retirement."

The usual consultative dance followed thereafter, with various industry bodies and a number of financial services entities providing feedback on CP101 and a subsequent consultation paper (CP122). ASIC's approach was to my mind thorough, seeking views from the Australian Government Actuary, who in turn consulted a number of actuarial firms for their views. In reading the final ASIC report on the matter (Dec 2011) it appears that ASIC has given its tacit approval for super funds to, if they so choose, prepare and present superannuation 'estimates' at the individual member level, without this being considered personal financial advice. This was implemented via the Class Order CO 11/1227 that you referred to.

The fact that no super fund (to my knowledge) has taken up the relief offered by CO 11/1227 is probably due to two factors. First, it was perhaps unfortunate that the two inquiries (Ripoll and Cooper) that led respectively to the Future of Financial Advice reforms (in the case of financial advice) and MySuper (in the case of APRA-regulated funds) happened in the intervening years. ASIC was asked by the government of the day to take into account the prospective changes that FoFA and MySuper would entail. This clearly muddied the waters in what was otherwise a pretty clear-cut case for allowing super estimates (both of lump sums and income stream equivalents) to proceed at the individual member level.

Secondly ASIC, having had to consider the impact of both FoFA and MySuper, adopted some of the industry feedback but held firm on the need for a single standard investment earnings rate (at 3% p.a. real) and for fees to be based on all actual administration fees and costs paid by the member over the preceding 12 months. Likewise estimates had to take into account the individual member's actual annual insurance premiums. The return calculation methods, as with the format of the presentation of estimates, are highly prescriptive and not conducive to the application of any marketing 'spin'.

What super trustees think of ASIC's final stance in their regulatory guidance on super estimates is not known, although I'd hazard a guess that the relief provided by the class order will not be utilised anytime soon. It is not that super trustees are apathetic to the potential engagement benefits that might be derived from providing members with individualised retirement projections. In my dealings with superannuation executives they are only too aware of the need to re-frame the conversation away from the dominant lump-sum mentality and toward retirement income adequacy. But the burdens of MySuper, SuperStream, FoFA and greater regulatory reporting obligations to APRA leave the issue of individualised retirement estimates as a distant 'nice to have, not need to have' on the agenda. As you point out super funds must now have product dashboards for their MySuper products. There will be many trustees and fund executives breathing a heavy sigh of relief at the just announced deferral (to 1 July 2015) in implementing the product dashboards for choice funds and in portfolio holdings disclosure .

I believe the provision of member estimates, both of retirement balances and their income-stream equivalent, will happen in due course. That replacement income-based projections are a reality in the Netherlands and Switzerland pension systems today suggests that the issues here are not insurmountable, whilst the benefits are many; members better engaged with the key decisions needed for retirement planning, and with information relevant for the task.

Richard Starkey

May 06, 2014

An update on CO 11/1227:
It is being used! I have assisted some large super funds to provide projections to members using the Class Order relief, and there are more coming on board.
ASIC issued a draft updated CO in 2013 as part of CP203, allowing the incorporation of the age pension, which in my view improved its relevance immensely. The Commission received industry feedback, but the release of the final version is still pending, apparently to allow the harmonisation of fee definitions with APRA. In the meantime ASIC has indicated that it is happy for the draft updated CO to be applied.
Nevertheless, due to the prescriptive methodology, I find that the implementation of the CO requires quite some judgement to ensure that projections are not provided to members for whom they might be misleading.

I have also assisted funds to provide member projections as statements of advice (ie not using the CO relief). I find this approach to be far more flexible, in particular in allowing for default returns that are more suited to the member current investment choice.

Richard Lambert

May 03, 2014

I think historically the reason for the lump sum preference was the favorable taxation treatment (only taxed on 5% of the receipt-even at 60% tax rate, a rate of 3%) Pensions were taxable in full.

The pension stopped at death, the lump sum could be left to children.

Dave Scott

May 02, 2014

Excellent article Bev. Most super funds in Australia only report an end of period balance. They might have a web based calculator to project a future balance based on various assumptions but they invariably allow the user to vary those assumptions. I don't think many members use these calculators or if they do then not in any constructive and informative way. A set of standard assumptions that all super funds use to then incorporate a retirement income projection in their annual of biannual statements might just engage more members to take greater control over what is a long term and critical investment. I hope your institutional clients heed your intelligent observations.

Bev Durston

May 03, 2014

Hi Dave,

Thanks for your comments. I think that the standard assumptions are absolutely necessary to allow comparisons across funds and help members get a total picture of income if they own several funds.

In the UK the regulator defines these and makes it compulsory to show the projection at 3 different rates of return. Interestingly the original rates to use were 5%, 7% and 9% growth rates on the investment. But in this new era of lower interest rates brought about by the GFC and financial repression these have been amended recently to 3%, 5% and 7%.

This highlights yet another way that information about retirement income savings can be sensibly communicated to members. The same pot size will then show a projected lower income in retirement as the growth rates are reduced.

Sadly DC people have not been warned of this topic because the accumulation pot approach does not typically allow for such messages to be communicated. This is yet another way in which DC members get a raw deal. All DB schemes have been markedly affected by the recent low interest rate market conditions - and have to deal with it to fund the incomes. In comparison poor DC members - even though they are also affected - have been sailing blindly through this period without any notice of the need to save more for retirement.

In my view using DB-like income reporting tools to DC members will also help them to grapple with the low growth, low return environment that markets have challenged them with since the financial crisis.

Bob Fairless

May 02, 2014

Its no wonder the 'old defined benefit schemes' of the public service and larger corporations were 'gold' if you happened to be a member of such a fund. Unfortunately most funds nowadays concentrate on DC approach and readily report what the lump sum may look like in the future. As Bev says most people hitting retirement age in an industry or retail fund have no idea how long it will last or how it should be invested to meet life expectancy. Often it will mean that their life in retirement will not look anything like the level of affluence they experienced whilst working. I guess that is why annuities have a place. Except that their costs and returns are mediocre on both counts but at least they provide some guarantee of consistent pay days in retirement.. Maybe they will be the halfway house result between DB and DC approach in the future. Challenger must think so as its where there marketing is pitched. I suspect the popularity of SMSF's as a growth sector has something to do with those more astute investors taking more interest in the longevity and maintenance of income into old age. Well written article and very timely. Still ignorance is no excuse for future poor results when it comes to taking care of ones' future.

Mark Thomas

May 02, 2014

Bev, Good article. You are correct. A dollar figure is much easier for the member to understand and has a much greater chance of fostering member engagement; and action when it is required.


 

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