Longevity risk cures worse than the disease

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Picture this. You and your wife have worked hard all your life. You’ve raised a family, put your kids through school and paid off a mortgage. You’ve done alright financially, accumulating a combined superannuation balance of $1 million, putting you in the top 5% of retirees. Now is the time to reward yourselves for the hard slog and sacrifice over all those years, before time catches up with you and it’s too late. However you want to be sensible so you go see your financial adviser.

Now you’re the adviser sitting across the table from this couple. You congratulate them on their retirement. They’re asking about safe withdrawal rates and making sure their money lasts as long as they do. Luckily, having recently read Morningstar’s ‘Safe withdrawal rates for Australian retirees‘ you have the answer. Their safe withdrawal rate is a dollar amount calculated as 2.5% pa of their initial retirement balance, indexed each year for inflation.

Less than the age pension

The couple does the maths and realises that this would give them an annual income (adjusted for inflation) of $25,000 pa. They say to their adviser that this cannot be right because if they had nothing they could qualify for the aged pension and receive an annual income of around $34,000 pa. The adviser helpfully points out that age pensioners also received reductions on property and water rates, energy bills, public transport and motor vehicle registration making the total pension package worth around $36,000 pa. Under the asset test changes effective from 1 January 2017, our couple would not be eligible for any age pension.

Based on a full pension package worth $36000 pa and Morningstar’s safe withdrawal rate of 2.5% pa, our couple would need a retirement balance of $1.44 million to derive an income from their account based pension that equals the aged pension. A combined balance of $1.44 million would put them in the top 2% of retirees. So unless you are advising only very wealthy clients, Morningstar’s safe withdrawal rate is of limited utility.

The gap in Morningstar’s analysis is that the minimum level of acceptable income for the self-funded retiree needs to offer more than they would receive on the age pension. Further, the definition of ‘ruin’ used to assess the safe withdrawal rate is inapprorpiate. Morningstar’s safe withdrawal rate is based on the likelihood of not running out of money. However, the 98% of retirees who’s retirement balance is less than $1.44 million would be better off (in terms of annual income) running down their account balance and becoming eligible to receive the aged pension rather than living a lifetime below the pension income.

What about an annuity?

Our couple leave their adviser’s office feeling discouraged. However, they recall seeing an amusing advertisement featuring a retired gentlemen setting off for a drive in the country in his sports car. So they look at what income they can receive with an annuity.

Our couple are both aged 65 and they consider purchasing a joint lifetime annuity with full inflation protection. The quoted rate of income is $3,109 per $100,000 investment. With their million dollar balance this equates to an annual income of $31,090. Our couple can lock in a higher annual income with a lifetime annuity than with Morningstar’s 2.5% safe withdrawal rate, but are still locking in a year one income below what they would receive on the aged pension.

Consider the ‘Rule of 5s’

What advice would I give our now woebegone couple? Try following the Rule of 5s:

  • Take 5% of their account balance ($50,000 for our couple) and spend it on an overseas holiday, a renovation of their kitchen, a new car or whatever the couple desires. This satisfies a behavioral desire for a reward after years of toil. It’s also recognition of premature mortality risk. That is, the risk of dying early and leaving too much money to your children.
  • Set a variable payment rate from their account-based pension at 5% of their balance recalculated each year. Taking 5% of their account balance would give our couple a first year income of $47,500, a reasonable increment on the aged pension. By making the income variable (as a % of the portfolio balance), the portfolio is more able to handle volatility in values as the drawdown adjusts to the ups and downs of the balance over time.
  • Invest in a mix of growth and defensive assets with a long-term expected return of at least 5% pa. I would say a growth / defensive split of 50/50. If the portfolio can generate a return of 5% pa, with the client redeeming 5% pa, then over time the dollar value of the portfolio should be constant (although it will gradually run out of purchasing power over time due to inflation).

Ultimately, even in the unlikely event their money ran out, the age pension is a back up, after many years of enjoying a lot more from life than 2.5% offers.

Gordon Thompson has worked for a range of major financial institutions in banking and wealth management since 1999. This article is general information and does not consider the financial circumstances of any individual.

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11 Responses to Longevity risk cures worse than the disease

  1. Ramani July 2, 2016 at 9:47 AM #

    The issues posed by the article, and the suggestions made, are sensible as no saver / couple is just a statistic contributing to the average, but a flesh-and-blood human, buffeted by emotions, irrational manias and phobias, relationship pressures and the fear of the unknowable.

    Perhaps we could look outside the box, learning from classical economics that now accepts behaviour – however untheoretical – as an integral part of human acts.
    As the aim is for the saver to live comfortably, apart from the suggestions, the following are worth consideration:

    1) The saver would have, during working life,cared for children by way of upkeep, education etc for at least two decades. Should not they have a role in stepping in, instead of leaving it all one way?
    2) Non-super savings (especially family home, not counted by Centrelink regardless of value) should be part of the solution, including recourse to reverse mortgages (to be compulsory for asset-rich, cash-poor seniors).
    3) As technology has advanced and global communications have expanded, higher and higher materialistic goals have skewed expectations and brought in their wake, disappointment. We need to rethink these.
    4) If it is ok to tax the living, taxing the dead should be a walk in the cemetery. This sacred cow has contributed to the longevity scare.

    These would not happen over-night or even years. But we should consider them lest they be forced upon us

  2. Anthony Serhan July 1, 2016 at 9:15 AM #

    Hi Gordon, I am a co-author of the Morningstar paper. Whilst it is great to keep the discussion on this important topic going, and to offer up some solutions, please don’t quote the 2.5% number from our paper out of context. At the bottom of the original article – thanks for including the link above – is a link to the full paper. Yes, we do say 4.0% would drop to 2.5% if you repeated the study with Australian data AND include a portfolio fee of 1.0% per annum. More importantly, the paper goes on to explore these rates using more diversified portfolios, expected (not past) returns, different risk levels, different retirement periods and different levels of certainty. Exhibit 13 shows a summary of the results. Taking a 50/50 portfolio of growth and defensive assets we calculated 30 different rates ranging from 2.2% for a 40 year retirement with 99% certainty of your money lasting, to 5.9% for a 20 year retirement with 50% certainty. The point is to understand the impact of these factors as part of selecting your withdrawal rate. We were bringing an investment lens to the topic. As has been rightly pointed out you also need to add social security and tax considerations to the equation. Anthony

  3. Margaret July 1, 2016 at 7:40 AM #

    A couple with over a million in their super who are advised to take out only Morningstar’s 2.5% annually must be planning a very long life, well over 100 years old.
    Into this discussion consider why many people, once paying off their houses then buy a property to rent out, to be paid off by the time they retire, to give another income stream. Australians who manage their money carefully, and whose other investments are managed through a SMSF realise that they can live another 30 years on considerably more than an average of $30,000 and many plan never to be a burden on the government. Your figures in this article are concerning – and unlawful as many people have pointed out SMSF people must take out a ini mum of 4% annually.

  4. Graeme June 30, 2016 at 8:33 PM #

    Meg; I doubt the government is ignoring running out of super. Isn’t one of the reasons for compulsory withdrawals to ensure that you do eventually run out of super, rather than pass it on to your kids? That’s why the withdrawal rates increase as you get older. All part of the deal of getting preferential tax treatment on super throughout your working and retirement lives.

    I take a different approach altogether. I turn 60 in a fortnight and so move into the super retirement phase. The bulk of my super will be in an account pension. Other than the compulsory 4%, I’ll make withdrawals if and when I need them. I’ll keep an aggressive asset allocation on the basis that if it works I will be ineligible for any pension. If it doesn’t, then I’ll likely end up on the pension. As Ian says, I’d then be no worse off than someone who took the responsible middle road.

  5. Graham June 30, 2016 at 6:45 PM #

    My rule of thumb is for a retired couple to have a pension and a half to live on each year.Lets face it if you are only getting the pension you would love even an extra $1,000 pa., let alone another $18,000 or so.
    So a lifetime annuity of $200,000,a ten year term annuity of $100,00 and $700,00 in the pension phase should easily get around $54,000 pa. In ten years,with Centrelink inflation indexation and deductible amounts on the lifetime pension surely some Government pension would then be received,replacing the term annuity. Much much better than relying on pension day.

  6. ian June 30, 2016 at 3:57 PM #

    Yes, I’m one of those 5% who “put away” (all of my working life) for their retirement only to find out that most of my friends who didn’t “put away” are doing better than me (on the pension).

  7. Meg June 30, 2016 at 3:38 PM #

    Interesting, but as it is mandatory to withdraw 4%,5%, 6%, 7% and more as one progresses through the retirement age groups, why even discuss how long Super will last at 2.5% or 5% as the drawdown must increase substantially with age?
    The compulsory % drawdowns mean that virtually all of us will run out of Super as we age – something that the Government seems to ignore.
    We have no choice in the matter!

    • Graham Hand June 30, 2016 at 9:26 PM #

      Hi Meg, it’s true that you might run out of super due to the high withdrawal rates, and as Graeme says, that’s what the super system is designed to do. But it does not mean you run out of money due to the high withdrawal rate, because you don’t need to spend it. You keep it outside super.

    • pedro July 1, 2016 at 10:16 PM #

      Meg I agree that the article should acknowledge mandatory withdrawal rates.

      However if you did some simple modelling you would see that by withdrawing a percentage of your portfolio, you will not run out of money. If you start drawing down a certain percentage and escalate that amount by CPI each year, it is possible to do so. This type of thinking led Bengen to propose the 4% safe wirhdrawal rate in 1994. Morningstar have simply revised this downward to account for today’s low investment returns.

      Bengen (and I assume Morningstar) assumed a 30 year retirement. With the Australian minimum drawdowns, your money will also last more than 30 years. I think we could all benefit from a more reasoned discussion taking into account Australian legal requirements addressing such issues as whether the minimum drawdown rates are appropriate and where should one re-invest if one does not spend ones entire super drawdown.

  8. Alex June 30, 2016 at 2:59 PM #

    Can’t ignore inflation – ie a portfolio returning 5% with 5% withdrawals leaves balance declining by inflation in real terms. So they will run out of purchasing power progressively over time.

    • Pedro July 1, 2016 at 9:52 PM #

      Alex Inflation matters but not near as much as you think. There are numerous studies which show that spending actually declines as you age. Just think about it -compare a fresh “65” year old active retiree with one who is 85 and think about possible differences in their lifestyles.

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