White Paper / Retirement Income Solutions RETHINKING ‘SAFE ...

White Paper / Retirement Income Solutions

RETHINKING

`SAFE' INVESTMENTS

FOR RETIREES

? In our latest Retirement Income white paper, Legg Mason and its affiliate Martin Currie Australia question whether retirees really need $1 million in superannuation to retire with a comfortable level of income, or if they instead should be looking at redesigning their asset mix.

? Our analysis has found that if investment products are designed with the objective to `maximise the probability of a stable and sufficient income for life', then income stability becomes more important than capital stability.

? Both Legg Mason and Martin Currie Australia have been developing retirement income solutions since 2010, with the successive launches of the Equity Income, Real Income and Multi Asset Income strategies. Each strategy has unique attributes within the Australian market and each has been built specifically with retiree income in mind.

YOUR LEGG MASON CONTACTS

Beau Titchkosky Head of Sales 0410 407 046 btitchkosky@

Tony Pattison Director of Sales 0448 277 060 tpattison@

Colin Taylor Director of Sales 0427 023 692 ctaylor@

Rosa Huddy Director of Sales 0429 205 069 rhuddy@

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1800 679 541

The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person. Legg Mason Asset Management Australia Limited (ABN 76 004 835 849 AFSL 240827) does not guarantee any rate of return or the return of capital invested. Past performance is not necessarily indicative of future performance. Investments are subject to risks, including, but not limited to, possible delays in payments and loss of income or capital invested. These opinions are subject to change without notice and do not constitute investment advice or recommendations. This document has not been prepared to take into account the investment objectives or portfolio needs of any person.

RETHINKING `SAFE' INVESTMENTS FOR RETIREES

WHITE PAPER

JANUARY 2016

FOR WHOLESALE CLIENTS ONLY

Back 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.

Reece Birtles Portfolio Manager

Will Baylis Portfolio Manager

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

nScaremongering on what retirement balance is needed does not deal with how money could and should be invested for a comfortable retirement

n 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

n Retirees should focus their asset-mix on sustainable and regular income that grows with inflation to meet their lifestyle needs, but most balanced funds focus on total returns only

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

nTerm 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

nSticking 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

nAustralian retirees should seek to match their A$ cost of living/inflation liabilities with A$ assets ? rather than diversifying, global assets may introduce additional unintended risks

nA multi-asset solution, focussing on A$ bonds, Australian shares with solid franked dividends, Australian real assets such A-REITs, utilities and infrastructure ? can be constructed to meet retiree income needs

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

n 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.

australia-institutional

RETHINKING `SAFE' INVESTMENTS FOR RETIREES

Of late, the government has started to look more closely at income objectives. The Financial Systems Inquiry (FSI) recommended in 2014 that superannuation fund trustees should be required to pre-select a comprehensive `income' product for retirement option (CIPR). This would let members receive their superannuation benefits in retirement, with features that include a regular and stable income stream1. In its response to the enquiry in October 2015, the government agreed that such products could lead to improved outcomes, increased private retirement incomes for retirees, increased choice and better protection against longevity and other risks2. 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 A$58,7843, 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 $33,982

Shortfall vs. Pension $24,802

Even at its maximum, the current full Age Pension of $33,982 p.a.4 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 (which are currently earning around 2.55%5), would need a retirement balance of well over A$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.

Do you really need A$1 million in super?

In 2010, the government's Cooper Review into superannuation stated that we needed around $500,000 in superannuation for a comfortable retirement. Today, Jeremy Cooper, the chair of the review, claims that $1 million is not even enough to reach ASFA's standards6. Mr Cooper's figures assume that the entire lump sum is invested in low-risk government bonds. He proposes that an annuity stream (such as what Mr Cooper's employer Challenger provides) is the only way to generate income in retirement.

What has changed? Have prices in Australia gone up that much? Have life expectancies increased dramatically in five years? No, the reason for the sudden change in his figure is that the yield on government bonds has fallen dramatically since 2010 to around 2.6%7.

Such a high retirement balance is out of reach of most ordinary Australians. In August 2015, the Australian Institute of Superannuation Trustees (AIST) estimated that the typical balance of those approaching retirement is just A$100,0008.

Public commentary has latched on to this A$1 million figure, but we believe that this is the wrong focus. Such statements send the wrong message to people approaching retirement. We should be looking at actual income delivered rather than just superannuation balances. Additionally, the A$1 million assumptions completely ignore the role of alternative asset classes that produce income.

1Commonwealth of Australia (December 2014). 2The Australian Government (October 2015). 3ASFA (30 June 2015). 4DHS (20 September 2015). 5RBA (30 September 2015). 6SMH (19 April 2015). 7Factset (30 September 2015). 8AIST (August 2015).

PAGE 3

An example: achieving a comfortable lifestyle

Let's assume a couple has a retirement balance of A$650k9 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 A$20k a year under the current asset test10. To achieve a `comfortable' lifestyle and avoid drawing on their capital, the couple would need to supplement the part pension with a further A$39k11 of income per year from their investment portfolio.

Annual income required for a comfortable lifestyle (AFSA)

$58,784

Part Pension example @ $650k assets

$20,001

Shortfall vs. Pension $38,784

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 Intergeneration Report12, a 65-year-old has about 20 years of life expectancy, and A$58,784 of expenses today could grow to almost A$94k 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.

Income growth required to maintain standard of living through retirement

160,000

Income from the Age Pension

Income required from investment portfolio

140,000

120,000 100,000

80,000 $58,784

$93,975

(Income p.a.)

60,000

40,000

20,000

0 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100

Past performance is not a guide to future returns. Source: Martin Currie Australia, ASFA, ATO, DHS; as of 20 September 2015.

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 A$39k p.a. from an A$650k 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.

9Based on ASFA's suggested `adequate' amount for a couple. Source: Yellow Brick Road (2015). 10DHS (20 September 2015). 11Martin Currie Australia, ASFA, ATO, DHS (20 September 2015). 12Commonwealth of Australia (March 2015).

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