The Retirement Income Covenant might want to place obligations on trustees to nudge members towards recommended retirement strategies, Geoff Warren argues.
With its latest position paper, Treasury seems to be moving further away from the idea of a default income product for retirement and more towards a strategic framework.
In its paper, Treasury says trustees will need to develop a “strategic document outlining their plan to assist their members to maximise their retirement income, manage risks to the sustainability and stability of their retirement income and have some flexible access to savings during retirement”.
The shift from a product to a principles-based framework makes sense, especially given the circumstances for each member differ greatly during retirement.
But it is equally true that an environment that relies fully on members making their own choices will expose significant groups of people to complex decisions that they are not well-equipped to make, Geoff Warren, Associate Professor at the Australian National University, says.
There may also be a group of members that might prefer to be just told what to do, rather than choose for themselves. Such types might welcome an opportunity to being guided by their fund towards a suitable strategy. This is not quite a default. We use the term ‘fund-guided choice’
“Essentially, what they seem to be saying is: ‘Choose for yourself.” The problem is that people could easily end up in the wrong place, especially if they are the sort of person who won’t pay for advice or perhaps just follows their mates,” Warren says in an interview with [i3] Insights.
“There may also be a group of members that might prefer to be just told what to do, rather than choose for themselves. Such types might welcome an opportunity to being guided by their fund towards a suitable strategy. This is not quite a default. We use the term ‘fund-guided choice’, on the basis that the member would be asking their fund to give some direction.”
The reality is that not every retiring member can rely on financial advice to point them in the right direction. There are simply not enough financial planners to provide a comprehensive statement of advice for every retiree in Australia, while for many the cost of such a statement is simply too high.
As an alternative, superannuation funds could offer members who are about to retire a recommended strategy upon request. This would be accompanied by clear information and interactive calculators that would allow members to better understand the strategy and choose an alternative strategy if it is unsuitable for their circumstances.
Strategies as Building Blocks
In terms of how strategies might be designed, Warren suggests “it would be useful to think of strategies from the standpoint of a building-block approach, rather than a one-cohort, one-product-type of solution”.
“The building blocks may consist of a growth portfolio and a defensive portfolio within an account-based pension structure. This could be combined with some sort of longevity solution or annuity. It doesn’t have to be annuities; it can be an embedded, QSuper-style product – a form of group self-annuitisation,” he says.
“These investment building blocks would be further combined with any entitlements a member might have to the age pension. The framework then needs to be rounded out with a drawdown strategy.
“Our research suggests there are two broad types of drawdown strategy. One is where you have a target income that you want to hit. Our modelling finds that it is often optimal to draw enough to bridge your target income until the account balance runs out. Longevity insurance then provides income when the money runs out.
“The other [drawdown strategy] is where you want to maximise the amount of spending you get out of your pot of saving. You initially work out how much you can afford to spend as a sort of sustainable drawdown strategy. Then you dynamically adjust depending on what happens. If you have poor returns and can afford less, then you cut back on income.”
Because members’ circumstances are so different once they enter retirement, some form of segmentation is necessary to design strategies that are appropriate for them.
With the odd exception, most funds will have a varied group of retirees. They may be single or partnered. Some own a house, while others rent. Some may wish to leave a substantial bequest, while others may only want to spend.
Warren agrees it is useful to divide a member base into different cohorts. “A segment of one is not feasible in retirement. Cohorting will be the natural first step to deal with heterogeneity,” he says.
Trustee Role
Key to the incoming Retirement Income Covenant is the obligation it puts on trustees to develop adequate and sustainable retirement income strategies for members. But what is the role of the trustee in guiding members to the right strategies, beyond simply offering a suite of options?
After all, funds can develop the most innovative and beneficial strategies for members, but there is a real risk members, or even financial planners, will not take up the offerings.
Warren says there are many practical obstacles to funds choosing a strategy for members. The two biggest hurdles are lack of information on members and the existing financial advice rules.
Warren contemplates whether the covenant should include some sort of obligation on trustees to engage with members over how they prefer to find a suitable retirement strategy.
Trustees might present members with the option to either choose for themselves, be referred to a financial planner or request their fund to either recommend a strategy or perhaps assign them to one. The last two options would come under ‘fund-guided choice’.
However, this would not deal with totally disengaged members who do not respond and could end up remaining in the accumulation phase, thereby maintaining a suboptimal strategy. Here there may be an argument for a default mechanism.
The heart and soul of the Retirement Income Covenant is the obligations it places on trustees. What the Government is aiming to do at this stage is to place an obligation on trustees to design a retirement strategy. That's where the rubber hits the road
“The heart and soul of the Retirement Income Covenant is the obligations it places on trustees,” Warren says.
“What the Government is aiming to do at this stage is to place an obligation on trustees to design a retirement strategy. That’s where the rubber hits the road. They’ll put it in the SIS Act (Superannuation Industry (Supervision) Act 1993), creating a legal obligation for trustees to make retirement solutions available.
“What I argued in a submission paper [to Treasury] is that there should also be an obligation on the funds to figure out how members want to find the right strategy. This obligation might also extend to keep on contacting members that don’t make a choice.”
He recognises any trustee obligations around member engagement are still some way off and are unlikely to occur until after the initial covenant has come into effect.
“If I read the tea leaves properly, the current aim is to put in place the covenant in order to get the funds developing their retirement strategies,” he says.
“My main hope is that the suggestion of opening up a path for funds to recommend strategies to members if requested to do so will be seen as worthwhile pursuing down the track.
“The idea of defaulting disengaged members seems harder to achieve. It is not the sort of thing you want to do quickly as it is tricky with lots of nuances. You’ve got to think about the unintended consequences.”
For [i3] Insight’s guide to retirement, please click here.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.