Everyone needs to rethink what income means in retirement. That's the message from the Government, and it will soon impose obligations on all super funds, including SMSFs, to provide a plan to maximise this form of income. In the Retirement Income Review papers released in July 2020, there is a definition which every super member needs to understand. In future, it will guide retirement spending policies and determine how super funds communicate with their members. "Retirement income: Income during retirement, including income streams and withdrawals from superannuation, the age pension, and drawdown of non-superannuation assets." While a more common definition of income is "money that is earned from doing work or received from investments" (Cambridge English Dictionary), add the word 'retirement' and 'retirement income' now includes:

• withdrawals from super
• age pension
• drawdown of non-super assets.

Yes, enter your retirement and draw $5,000 from a bank account to go on a holiday, and that's retirement income. Get used to it.

The Retirement Income Covenant

The argument that retirees should draw income from assets has been taken further in the newly-released Retirement Income Covenant position paper, with the Covenant operational from 1 July 2022. It requires every super fund to provide a document: “… outlining their plan to assist their members to achieve and balance the following objectives:

• maximise their retirement income
• manage risks to the sustainability and stability of their retirement income; and
• have some flexible access to savings during retirement."

And the use of 'retirement income' here is consistent and deliberate.

No industry-wide agreement

A comfortable standard of living for a couple in retirement at age 65 according to ASFA requires $62,828 a year, assuming home ownership. If they have investible assets of $1 million and they do not want to spend their capital, that means an income of 6.28% is required. That's a big ask these days without a fair amount of equity-type risk in a portfolio, which is where the drawdown of capital comes in. There are many views on a safe withdrawal rate for a retiree not to run out of money. Traditionally, 4% was considered appropriate. The ‘4% rule’ started in 1994 with an article published in the Journal of Financial Planning by William Bengen. He explained where the rate came from in this Firstlinks article and of course, interest rates were much higher 27 years ago. As interest rates fell, many people argued for 3% or less, such as in 2016 when Anthony Serhan (then Morningstar's Managing Director, Research Strategy) wrote in Firstlinks about withdrawal rates and concluded: “Safe withdrawal rates for retirees now need to start at 2.5%.” This is not much to live on, only $25,000 on $1 million, and there is no magic silver bullet in investment markets. The Government will require trustees to educate their members about using their capital but trustees know they cannot guarantee their members will not run out of money using any traditional products. The Covenant draws on the Retirement Income Review in making the case to retirees: “Partly because they have only ever been primed to save as large a lump sum as possible, retirees struggle with the concept that superannuation is to be consumed to fund their retirement. Because retirees struggle to develop effective retirement income strategies on their own, much of the savings accrued by members through the superannuation system are not used to provide retirement income. Rather, they remain unspent and become part of the person’s bequest when they die. Multiple studies have shown that retirees die with around 90% of the assets they had at retirement. Without a change in behaviour, it is expected that bequests from superannuation will grow. By 2060, it is projected that 1 in every 3 dollars paid out of the superannuation system will be a part of a bequest.” Research by David Blanchett and Michael S Finke supports the view that retirees fear running out of money. Retirees will spend twice as much each year if they shift investment assets into a source of guaranteed income, finding:

• Longevity risk (the fear of outliving their savings) results in lower spending, and
• Behavioural preferences make retirees more comfortable spending from income than assets.

The most important statement in the 648-page Retirement Income Review is: "... retirees die with around 90% of the assets they had at retirement." It is the primary justification for developing policy requiring spending and not bequeathing. Yet Ross Clare, Director Research at the Association of Superannuation Funds of Australia (ASFA) wrote an article in Firstlinks called "In fact, most people have no super when they die". It would be hard to find a bigger range from two authorities on the same subject than close to zero and close to 100%. Just in case SMSF trustees think the deliberations are only for the consultants, professional fund managers and trustees of large funds, the Government makes it clear that SMSF trustees have obligations as well. It says: “Trustees of SMSFs and SAFs (Small APRA Funds) with retired members should have a retirement income strategy... (they) are not expected to develop their strategy for cohorts of their members, given their small size. However, if trustees of SMSFs and SAFs identify that their members need markedly different approaches to balance the objectives under the strategy, they are not precluded from developing their strategy for cohorts of their members.”

The Covenant provides few clues

For all its arguments about the benefits of providing members with retirement products tailored to their needs, the Covenant provides few hints on how to achieve the outcome. It includes hopeful statements such as: “... the strategy should identify how trustees intend to assist their members to balance these objectives and whether the trustee’s intended assistance is likely to increase or decrease the retirement incomes of their members.” Or this gem that reads as if from an undergraduate economics exam where the strategy is a strategic document (sic): “In effect, the strategy is a strategic document developed by the trustee that:

• identifies and recognises the retirement income needs of the members of the fund; and
• presents a plan to build the fund’s capacity and capability to service those needs.”

There is even doubt about whether the Covenant is possible to implement under current regulations. Dr Pamela Hanrahan recently told a Conexus Institute webinar that trustees are limited in their ability to provide tailored advice for members, and the Covenant probably falls foul of the distinction between general and personal financial advice. The Government’s own policies on drawdowns are confusing. At the same time as they are advocating retirees spend their capital, they reduced the mandatory minimum amount required to be withdrawn from a pension account by 50%. Initially, this was due to the pandemic, but it was recently extended for another year after the market had strongly recovered. Not much merit in having a Retirement Income Review and now a Covenant arguing retirees should take money out when the Government then says leave it in. As the Covenant paper gives trustees an obligation to develop retirement strategies without prescriptions, it will lead to a vast range of different outcomes, including some trustees who believe their current product range is fine. Complicating matters, at a time when the risk-free bond rate is close to 1% and stockmarkets are at all-time highs and expensive by most standards, trustees cannot simply offer promises of attractive investment returns to satisfy retirement income needs. Consider this chart, provided by First Sentier Investments, which shows the capital loss from a 1% rise in rates, on a range of bond indexes. Bonds are supposed to protect investor portfolios in times of distress. For example, in Australia, the government bond index has a duration of 6.8 years, meaning a 6.8% loss for a 1% rate rise. Trustees cannot rely on the past successes in the way a simple 60/40 portfolio delivered handsomely in a retirement.

Examples of retirement income products

In recent weeks (including this week), Firstlinks has published five articles with different solutions to the retirement income challenge, plus an earlier sixth article on lifetime annuities. Let’s quickly examine the six. Most of these are complicated structures and there is not space here for a full review.

1. Investment-linked lifetime annuities

These products, such as offered by Optimum Pensions and QSuper, are a form of investment-linked annuity which invests in a balanced fund with growth exposure, supported by some longevity insurance. The aim is to bridge the gap between the usual account-based pensions and lifetime annuities with fixed payments. Each year’s income varies based on the performance of the selected investment option, rather than as a specific dollar amount of income. It is designed to give retirees confidence to invest in growth assets while drawing down their assets. Optimum Pensions buys longevity insurance from Hannover Re, while QSuper buys a policy provided by QInsure, an insurance company fully owned by QSuper.

2. Magellan’s FuturePay

Magellan’s new product is an equity fund that pays a regular, inflation-linked income. It is protected by a Support Trust, initially seeded by Magellan with $50 million, paid in increments. There is also a committed a reserve facility equal to 2% of the fund, capped at $100 million to "provide additional support during poor market conditions". Payments into the Support Trust will flow from two key sources. First, when investors purchase units in the fund, a small amount of capital will be contributed from the fund to the Trust. Second, in rising markets, where the portfolio is outperforming its inflation-adjusted index, FuturePay may reserve a portion of its outperformance by contributing capital to the Trust. The assets in the FuturePay Support Trust do not form part of the assets of the fund. Investors who redeem units will receive the value of the investment portfolio but they leave behind their benefits in the reserve, which is why Magellan calls it a 'mutualisation' of the fund. The structure relies on strong markets in its early stages to build up the reserve and investors should consider they are in for the long haul.

3. Balanced funds in an account-based pension

The account-based pension is the most common way Australians finance their retirement. The pension phase may differ in its asset allocation from the earlier accumulation stage, although with more people living 30 years or more in retirement, a switch to defensive investments paying negative real rates is less attractive. The pension works by the retiree withdrawing whatever is required for a chosen lifestyle (subject to mandated minimums) and hoping the outflows are covered by income. This article by Martin Currie Australia is an example of the retirement solution without any specific protection included. Over the long term, stockmarkets generally rise and deliver an increasing dividend stream, supported in a balanced portfolio by more defensive assets to reduce volatility. By focussing on assets that generate a high and stable franked income stream through diversified sources, most retirement objectives can be met. When I worked at CFS a decade ago, the main reason little work was done on a special ‘retirement income product’ was a belief that over time, a balanced account-based pension was a good solution. However, that was when the bond allocation could deliver closer to 8%. Some trustees of large super funds may argue the traditional approach is best for their members given the complexity and costs in other solutions.

4. Pooling among many members

A feature of life expectancy is that over half the people of a certain age will live longer than their expectations. However, pooling a large group of retirees of the same age will give a reliable distribution of ages at death. As the pool gets larger, the distribution of lifespans around the mean is more predictable. The benefits of pooling can be passed on to retirees. Super funds can provide lifetime income products by pooling together retirees’ capital through group self-annuity. With enough members, they can reduce the uncertainty for individuals in the group. Like a traditional defined benefit fund, super funds could hold reserves to support a pooled product, either permanently or until the pooled product reaches scale. The reserves can be used to smooth benefit payments and reduce the volatility for members.

5. Protected income products

The Allianz Retire+ ‘protected retirement product’ is designed as part of a portfolio’s defensive allocation. It is a long-term investment that discourages individuals from withdrawing their investment early as the value at early withdrawal is subject to market conditions. As an example of current returns using a protection strategy with an investment of 50/50 in S&P/ASX 200 Total Return (3.50% cap) and MSCI World Net in AUD (3.20% cap) with a zero loss tolerance (before fees), a retiree could earn a maximum potential return of 2.55% pa if held for the full seven-year term.

6. Lifetime annuities

The leading offers of the longstanding solution in the retirement space, lifetime annuities, are provided by Challenger and AIA. A lifetime annuity pays a guaranteed stream of income for life, with a potential option to pay a surviving spouse. This income is usually fixed or set to increase in line with inflation. The key feature of the annuity is the guarantee, backed by capital from a life insurance company. Innovations over the past decade have seen many features added to life annuities in Australia. A typical example of a lifetime annuity is:

• $100,000 invested at age 64, life expectancy to 84, payment adjusted at CPI of 2.5%.
• At age 65, annual income $3,905, death benefit, $100,000. By the age of 74, income has risen to $4,877, death benefit still $100,000, but capital then starts to fall until it reaches zero at age 84.
• At age 84, income now $6,243, death benefit zero.
• At age 104, income $10,229.

In order to have more ‘income’ to live on, a retiree must draw on their capital later in life. In this example, after the age of 84, the income level is sustained until death but the capital has gone. Of course, the amounts above are in future dollars, CPI adjusted, and the annuity providers say this should be only part of the overall retirement solution as it does not have everything that a retiree might need.

A wide range of retirement income solutions is coming

The vast majority of people no doubt think income and capital are different. If someone invests $100,000 and earns $2,500, this represents their ‘income’. If they drawdown ‘income’ of $10,000 from an account (super or not) but their capital is now $92,500, few people will call this $10,000 of income. Most members of large super funds will be confused by the product complexity of the coming retirement income products, and they may leave it for the fund to select a product for them. The major challenge will be communicating this complexity to the millions of members who are relatively disengaged, and talk of longevity insurance will make it more difficult. There is no silver bullet and we all have to cope with a unique definition of income.