I confess to being a non-believer in silver bullets in the context of post retirement products. The silver bullet is probably not a product, but good financial advice. However, I also admit that my view on the product silver bullet has changed over the last two years, and I am now more of a believer than I was.
What does our post retirement look like?
Contrary to some commentary this year, our post retirement system is in reasonable shape. According to Rice Warner, 85% of client assets are invested in income streams. Those taking lump sums generally have small balances and appear to be doing sensible things with them, like paying off debt. We have a reasonable array of post retirement products in the retail market (account based pensions, annuities, variable annuities) and the recent Melbourne Mercer Global Pension Index 2014 ranked Australia second in the world.
However, there’s a bit that’s not great. There are mounting longevity challenges. Mercer’s data shows there’s a 35% chance that a white collar fund member retiring now will live to 91 if they are a man and 93 if they are a woman.
With 93% of retail money in account based pensions, it’s clear that most members have little longevity protection (apart from the age pension). Our exposure to annuities is significantly lower than many other major countries, some of which have more than 50% of their retirement assets in annuities.
Burnt by the GFC, many investors remain risk averse with lower exposure to growth assets, with comments like this being the norm: “More than anything, I want to ensure that my husband and I have financial security and safety for our money … nothing too risky.” This thinking is showing through in spades in both quantitative and qualitative research at Colonial First State.
Even though our system ranked well in the Mercer study, the Global Age Watch Index 2014 ranked Australia behind France, Canada, UK and the US for income security. This measure took into account pension coverage, levels of poverty in retirement (defined as half average earnings) and income replacement for the population over age 65.
It’s not surprising that the Financial System Inquiry Interim Report commented, “the retirement phase of superannuation is underdeveloped and does not meet the risk management needs of many retirees”.
For a while, many believed variable annuities were the silver bullet. In some ways they can seem to offer the upside of equity markets with the downside protection of a lifetime annuity. With around $2 trillion of assets invested in them, they have certainly been popular in the US. However, their success has come under a cloud since the GFC, with a number of providers exiting the market due to problems with hedging their exposures. In addition, it is apparent that the factors that have driven their growth in the US are not translatable to the Australian market. Commissions of around 7% are reportedly common and there are tax advantages that are specific to the US. With about $2.6 billion invested in variable annuities in Australia, there has been some interest, but it’s clear they are probably not the silver bullet.
Global changes provide pointers
Three global changes might provide an idea about the worldwide view on the silver bullet.
In 2012, the OECD Working Party on Private Pensions developed a series of 10 recommendations for the “good design of defined contribution pension plans”. The seventh recommendation was “for the payout phase, encourage annuitisation as a protection against longevity risk … A combination of programmed withdrawals with a deferred life annuity (e.g. starting payments at the age of 85) that offers protection against inflation could be seen as an appropriate default”.
In addition, the US Government recently made changes to allow 401(k) savings to be invested in deferred annuities, whereas the UK Government removed the compulsory annuitisation. And there are changes happening locally. The Government is looking at deferred annuities, with Treasury having released a detailed discussion paper.
There are also changes in sentiment by financial advisers. Inflows into lifetime annuities increased 35% last year according to Plan for Life, and Zenith recently created a model portfolio for retirement which includes an allocation to annuities. Furthermore, a recent Investment Trends survey showed that 37% of advisers said they would like to use some sort of annuity in the following 12 months (Investment Trends Retirement Income Report 2013).
Using scenario modelling
Our approach to trying to find the silver bullet was to commission Ernst & Young to do some scenario modelling. Their quest was to find what product combination delivered the best outcomes for customers in retirement. They built a stochastic model of the different products that are available in the market – lifetime annuities, deferred annuities, term annuities, variable annuities and account based pensions. There were two key conclusions.
Firstly, the variable annuities didn’t model well, mainly because of the high fees and the lack of flexibility in the product design.
Secondly, the ‘hybrid’ options, where an annuity (lifetime or deferred lifetime) is combined with an account based pension often delivered superior outcomes for members.
Much as I would like to think our modelling delivered unique insights, similar conclusions have been derived elsewhere.
In particular, there is academic work showing that a small allocation to an annuity (say 10-20%) can deliver better outcomes for customers. Indeed, David Bell wrote an article in Cuffelinks entitled ‘Why academics like lifetime annuities’ where he commented, “financial models suggest life annuities are beneficial to rational decision-making individuals, yet in Australia the number of life policies purchased remains small.” There is also work by Mercer on behalf of Challenger which has similar findings. Given the OECD roadmap and the US changes, it appears they might have also reached similar conclusions.
Closer to the silver bullet?
It would have been great if I could say that I have discovered a new, sexy, amazing, innovative, silver bullet. Instead, I’m afraid the answer is rather dull. ‘Partial annuitisation’ with a modest allocation might be as close as we can come to the product silver bullet.
If combining an annuity and an account based pension is the answer, we need to make it easy for advisers to construct, report on and maintain such portfolios on behalf of their clients.
Nicolette Rubinsztein is General Manager, Retirement and Advocacy, Colonial First State. She has been on the Board of The Association of Superannuation Funds of Australia (ASFA) since 2007 and chairs ASFA’s Super Systems Design Policy Council.