RETHINKING ‘SAFE’ INVESTMENTS FOR RETIREES B

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February 2016

Reece Birtles, Martin Currie Australia

Will Baylis, Martin Currie Australia

Birtles joined Martin Currie Australia

in January 1995 as a research analyst. In

2003 he moved to London as global equity

portfolio manager and head of financials

research, before being promoted to head

of European equities. Reece returned

to Australia in 2006 as chief investment

officer of the firm.

Baylis joined Martin Currie Australia

in July 2013 after 16 years at Deutsche

Bank in various roles including research

sales, head of Australian equity sales and

account management, as well as head of

the Melbourne equities desk. Will is a

Fellow of Finsia and an Affiliate of the

Australian Securities Exchange.

RETHINKING ¡®SAFE¡¯

INVESTMENTS FOR RETIREES

B

Reece Birtles and Will Baylis

ack in 2010, Martin Currie started to look at

how the ageing population was changing the

retirement environment in Australia, and how

people moving into retirement were actually

going to fund their retirement.

The volatile total return experience during the

global financial crisis (GFC) had led people to

lose faith in traditional equity strategies. At the time, there was a big

focus on how ¡®fixed annuity¡¯ products could be the solution, but given

the low returns available from such products, we were not convinced.

We started to think about the problem from a more fundamental perspective, and went back to first principals to look at product design. For the previous 20 years, the industry had focused on

building products for accumulation strategies, where the goal was

to maximise the total dollar balance before reaching 65 years of

age. There had been no focus on building solutions specifically for

retirement income.

We believe that if products are designed with the objective to ¡®maximise the probability of a stable and sufficient income for life¡¯ then

income stability is more important than capital stability. The objective of retirees shouldn¡¯t be on reaching a particular dollar balance.

Key findings

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Scaremongering on what retirement balance is needed does not

deal with how money could and should be invested for a comfortable retirement

The Age Pension is not a safety net for a comfortable retirement,

and unless balances are very large, term deposits no longer provide

the required income yield to meet the short fall

Retirees should focus their asset-mix on sustainable and regular

THE JOURNAL OF SUPERANNUATION MANAGEMENT?

income that grows with inflation to meet their lifestyle needs, but

most balanced funds focus on total returns only

For retirees, income stability should be more important than capital stability or total returns

Term deposits are not risk free: they have over twice the income

volatility of an investment in equities, and capital often has to be

eroded to meet income goals

Sticking to a single asset class (such as term deposits) or investing

in the wrong combination of asset classes could leave retirees with

the burden of running out of money

Australian retirees should seek to match their A$ cost of living/

inflation liabilities with A$ assets ¨C rather than diversifying, global

assets may introduce additional unintended risks

A multi-asset solution, focussing on A$ bonds, Australian shares

with solid franked dividends, Australian real assets such A-REITs,

utilities and infrastructure ¨C can be constructed to meet retiree

income needs

At Martin Currie Australia, we offer a unique Multi Asset Retirement Income solution that is managed specifically from a retiree

perspective.

This new approach provides retirees with the expected benefits of

low volatility (fixed income), inflation protection (real assets) and

long-term income growth (equity income), which combined minimises the need to draw down on capital and provides higher yields.

Of late, the government has started to look more closely at income

objectives. The Financial System Inquiry (FSI) recommended in

2014 that superannuation fund trustees should be required to preselect a comprehensive income product for retirement (CIPR).

This would let members receive their superannuation benefits in

retirement, with features that include a regular and stable income

stream. In its response to the enquiry in October 2015, the govern-

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February 2016

ment agreed that such products could lead to improved outcomes,

increased private retirement incomes for retirees, increased choice

and better protection against longevity and other risks. The government has committed to consult with industry by the end of 2016 on

specific legislation.

We are not making a judgement here on whether options such

as account-based pensions, annuities or other types of guaranteed

investments are the most appropriate default CIPR vehicle, as in

our opinion one size does not fit all. Rather, we have been looking at

the characteristics of investment products that could be used within

an income solution for a superannuation fund, SMSF or individual.

In its response to the FSI, the government highlighted that the

range of products currently available at retirement is too narrow and

does not always meet individuals¡¯ needs and preferences. We agree

that products designed for traditional pension portfolios, such as

fixed annuities, are unlikely to be able to provide a comfortable retirement with a stable and sufficient income. We need products that

are specifically designed for retirees¡¯ needs.

Quantifying the problem

According to the Association of Superannuation Funds of Australia (ASFA), a comfortable retirement lifestyle for a couple aged

65 can be achieved with an income of $58,784 (as at 30 June 2015),

assuming that the retirees own their own home outright and are

relatively healthy.

Annual income required for

a comfortable lifestyle (AFSA)

$58,784

Full Age Pension

Shortfall versus Pension

$33,982

$24,802

Even at its maximum, the current full Age Pension of $33,982

p.a. (as at September 2015) is nowhere near sufficient to cover this

amount for a comfortable retirement; retirees would need to supplement any pension income with income from their own investments

and superannuation.

Retirees who look to derive their comfortable income entirely from

annuities, or term deposits ¨C which are currently earning around

2.55% according to the RBA in September ¨C would need a retirement

balance of well over $1 million to last for 20 years of life expectancy.

This sum is out of reach for nearly all people who are approaching

retirement, even if they are earning very high incomes.

An example: achieving a comfortable lifestyle

Let¡¯s assume a couple has a retirement balance of $650,000 available in an accumulation-focused superannuation fund. While this is

above the asset threshold for a full pension, the couple is likely to be

eligible for a part pension of approximately $20,000 a year under the

current asset test (as at September 2015). To achieve a ¡®comfortable¡¯

lifestyle and avoid drawing on their capital, the couple would need to

supplement the part pension with a further $39,000 of income per

year from their investment portfolio.

Annual income required for

a comfortable lifestyle (AFSA)

$58,784

FS Super

Part pension example

@ $650,000 assets

Shortfall versus Pension

$20,001

$38,784

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They also need that income to grow over time, by at least the

inflation rate, to maintain its purchasing power. According to the

government¡¯s Intergenerational Report, a 65-year-old has about 20

years of life expectancy, and $58,784 of expenses today could grow

to almost $94,000 in 20 years¡¯ time. The solution needs to provide

sufficient income growth over time to offset the loss of purchasing

power from inflation. As an added hurdle, inflation for retirees can

be effectively higher than the official statistics suggest, because they

often have to spend more on healthcare. However, here we will assume 2.5% for illustrative purposes. (See Figure 1.)

The objective is to build a portfolio that produces a certain dollar

income to match lifestyle needs, and grow that income each year in

a stable and reliable fashion.

This is quite a different starting point to what the industry as

a whole had been doing before. The focus had always been on

¡®what¡¯s the total balance of the fund?¡¯ We believe that the focus

for post-retirement should really be on sustainable and regular

income amount.

Using our prior asset/liability assumptions, generating an income

of $39,000 p.a. from a $650,000 balance requires around a 6% p.a.

yield. Therefore, we need to design portfolios that will generate in

excess of a 6% p.a. yield in order to meet the income needs.

How does your risk tolerance change with

asset size?

It feels intuitive that people with lower assets should have a lower

risk tolerance compared to people with higher assets. However, to

reach the income requirements of a comfortable lifestyle in retirement through investing, the lower the asset size, the higher the yield/

risk required. On the flip side, the higher the assets, the lower the

yield/risk required to attain a comfortable retirement. Is this a mismatch? Maybe not.

Consider this: The lower the value of your retirement savings,

the greater reliance you have on the Age Pension. The Age Pension

is guaranteed by the government, and so could be considered similar to a risk free return.

The present value of the full Age Pension of $39,000 p.a. or

around $676,000 over 20 years, and for low-end asset levels, makes

up around 70% of total assets. However as your assets grow, your

access to the Age Pension decreases, and your risk tolerance in fact

decreases as the percentage of your assets in ¡®risk-free¡¯ investments

fall. Ironically, given the Age Pension safety net, the lower the value

of your retirement savings, the more risk you can take to invest your

remaining savings in higher yielding strategies.

Retirement

savings

Full Pension

Present value of

Age Pension

$291,500

30%

Part Pension example

@ A$650K assets

$650,000

62%

$676,501

Total

$968,001

70%

100%

$398,163

$1,048,163

38%

100%

Figure 2 highlights the required yields for attaining a comfortable

income at different asset balances and the interaction of asset size

with Age Pension eligibility, ignoring the potential changes to legislation of pension entitlements or superannuation concessions.

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Why have things changed?

Figure 1. I ncome growth required to maintain standard of living

through retirement

Figure 2. R

 equired yield and asset sizes for comfortable

retirement incomes

Prior to the GFC, term deposit rates well in excess of 6%

were readily available, and it would have been possible to

annuitise a retirement balance and live comfortably off

that. However, rates on term deposits have plunged over

the last decade. Since the GFC, there has been a general fall in official interest rates, both here and overseas,

with the yield on Australian 90-day bank bills falling to

just over 2.5% in December 2015. To generate the same

dollar of income from term deposits today requires an

investment of up to four times as much as it did in 2008.

This lower income generation per dollar also means that

that there is a greater chance that the retiree will have to

draw down their capital assets in order to meet the cost

of living.

Where else can we find our required yield of greater

than 6% p.a.? Growth assets such as equities offer an

alternative, but introduce different risks and questions to

the drawdown-on-capital debate.

How do you choose when to sell? Which assets should

you sell? This uncertainty can make retirees feel uncomfortable about being exposed to the volatility of equity

markets, and by extension feel uncomfortable about being invested in growth assets at all.

Avoiding drawdowns on capital with

an income focus

Figure 3. Annual income received from $100 invested 10 years ago

We believe that if we can design portfolios that can provide retirees with their required income, year in and year

out, then they can take a longer-term perspective. That

means they can rid themselves of the worry about selling

their assets at the wrong time. This enables them to hold

more ¡®growth¡¯ assets in their portfolio, which in turn enables the portfolio to have growth in the income stream

over time to keep up with inflation. Income growth

would not be possible in traditional fixed-annuity products, leaving them exposed to income erosion.

We need to change the investment focus from valuing total returns to valuing income returns. If we can

increase the percentage of the total return in the form of

income, this means that we do not need to fund income

from capital gains.

For Australian retirees, if we account specifically for

the franking credits as part of that income focus, there

is an additional benefit to invest in Australian equities.

Our internal analysis indicates this can increase returns

for a retiree in the order of 1.8% per annum gross of fees.

Do you know about hidden volatility?

Most investors understand the concept of capital volatility; we all know that share prices go up and down. The

volatility of Australian share prices (S&P/ASX 200 Accumulation Index) over the last ten years to December

2015 has been around 17.4% p.a. (according to FactSet

data). Interestingly, the volatility of the dividend stream

produced from the same index has been 9.1% p.a.; far

more stable than the underlying share prices.

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For term deposits, or even fixed annuities, capital volatility has been stable over time. But when you look at the

income stream produced by those assets, it¡¯s actually had

volatility of 22.5% p.a. over the same period according

to the RBA (See Figure 3). That¡¯s more than double the

volatility of equities! What assets are risky now?

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Figure 4. Income vs. income risk from the perspective of a retiree

A new frontier

Most investors would be familiar with the upwards sloping

¡®efficient frontier¡¯ chart, which explain that more risk taken

results in a greater expected total return. However, when

thinking about a retiree¡¯s needs, the focus should be on income returns rather that total returns, and income risk rather than total risk. When constructing a profile for incomegenerating assets and income risk, the efficient frontier has

a very different shape to a normal investment frontier. We

have compared income return and risk for each of the asset

classes typically included in an accumulation portfolio. We

also looked at if their current yields meet the minimum 6%

income threshold for retirees (See Figure 4).

This analysis has shown us that very few asset classes

meet the income threshold. Term deposits have the lowest levels of returns, but sit among those with the highest

variability of income over time. A passive investment in

Australian equities or listed property also doesn¡¯t meet

the grade, however, we believe that an portfolio with a

specific income focus would.

Figure 5. Government debt to GDP I Central bank assets: % of GDP

Global equities: challenging the

traditional asset mix

Another interesting outcome of our analysis is that

global equities might not be appropriate for all retirees,

even though they have been traditionally included in the

30/70 mix as a growth component.

A typical conservative balanced fund invests in global

bonds, global equities, Australian bonds and Australian

equities. But in our asset/liabilities match for retirement

income, the liabilities (cost of living) are largely Australian, inflation is largely Australian, therefore the risk to

the investor is largely Australian in nature. We believe

that the assets in which you invest should match your income objectives. For example, a fall in consumer prices

in say New York or London will not boost your spending

power as a retiree in Melbourne or Sydney. For this reason alone, offshore investments may have a disadvantage

relative to local investments for Australian retirees.

Additionally, typical accumulation stage clients would

be happy to take on the ¡®diversifying¡¯ foreign-exchange risk

that comes with investing overseas. They don¡¯t mind that

the dividend yield is only around 2.5%, as the focus is on

maximising total returns. But when you look at this from a

retirement perspective, if you are only getting a 2.5% yield

for foreign equities, you would need to draw down at least a

further 3.5% of capital over time to meet the income threshold. Furthermore, foreign-exchange risk, rather than adding diversification, has actually introduced an additional

unintended risk in volatility of the income stream.

FS Super

Why Australia is a safer source of

income

One of the big concerns stemming from the GFC is that

countries in the northern hemisphere have taken too

much debt on to their government balance sheets. This

has clear implications for their fiscal positions, in terms

of funding that debt, and what it means for their budget

and ability to spend in the future. Thankfully, Australia

is in a much stronger position compared to other markets

(see Figure 5).

But this dynamic in the northern hemisphere has

consequences for asset classes everywhere around the

world. If you look at essentially the ¡®zero-interest rate¡¯

policies that the US, Europe and Japan have today, you

can see that returns from many asset classes have become distorted versus pre-GFC. However, Australian

equity yields remain attractive compared to their preGFC levels. (See Figure 6.)

The quote

We are not making

a judgement here

on whether options

such as accountbased pensions,

annuities or other

types of guaranteed

investments are the

most appropriate

default CIPR vehicle.

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February 2016

Figure 6.

Despite these headwinds, Australian equity yields

have remained attractive compared to pre-GFC levels.

Australia continues to be a safer source of income; with

higher interest rates, a low-risk environment and a tax

system that favours dividends. Australia has solid economic prospects, robust population growth (assisted by

net migration), a sound fiscal position and low political,

legal and corruption risk. The country is also home to

many strong companies and a solid banking system, and

corporate debt levels are at decade lows.

Figure 7.

Summary of the retirement challenge

Focusing on Australia

The quote

The objective is to

build a portfolio that

produces a certain

dollar income to match

lifestyle needs, and

grow that income each

year in a stable and

reliable fashion.

Even if you believe that the US Federal Reserve will raise

rates, be it this year or sometime in the next few years, it¡¯s

very unlikely that yields will go back to the long-term levels

that existed prior to the GFC. Cash rates around the world

have been significantly reduced, and there is no way you can

achieve a 6% yield out of any cash-type instruments today,

and this is also unlikely to rebound to that level in the future.

Similarly, that dynamic can also be seen in government bond markets, including Australia, and it¡¯s also

affected corporate credit yields, and securities such as

US and Japanese REITs. These are now much closer

to what you see in bond yields.

THE JOURNAL OF SUPERANNUATION MANAGEMENT?

We are concerned that sticking to a single asset class or

investing in the wrong combination of asset classes could

leave retirees with the burden of running out of money,

and the Age Pension does not provide a full safety net for

a comfortable retirement.

As we have discussed above, we believe the solution to

meeting retirees¡¯ income needs lies in prioritising income

at the heart of the asset allocation for client portfolios.

We believe that if products are designed with the objective to ¡®maximise the probability of a stable and sufficient

income for life¡¯, then income stability is more important

than the oft-quoted required balance of $1 million or

even more.

By changing the investment focus from valuing total returns to valuing income returns, we can reduce

the need to fund income from capital, and avoid capital drawdowns. Although term deposits provide capital

stability, they have the lowest levels of returns but sit

amongst those with the highest variability of income

over time.

FS Super

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