Lifelong clients

Financial advisers often consider the retirement phase to be one of the more difficult areas on which to advise, but the ever-growing proportion of Australians reaching retirement means it is also becoming one of the most critical.

According to the Actuaries Institute, by 2050 almost one quarter of the Australian population will be aged 65 and over – with four million baby boomers planning to retire in the next 15 years.

The Actuaries Institute also expects average life expectancy to continue to rise, from the current ages of 84 for men and 87 for women, by an additional two years. This increase in life expectancy creates greater uncertainty around longevity.

While some retirees may die in the early years of their retirement, more than half will live past the average life expectancy. This longevity risk makes calculating expenditure during retirement extremely difficult.

The inadequacy of people’s retirement savings is another issue impacting the income of retirees.

A survey conducted by MLC revealed around one third of all Australians expect to have a significant financial shortfall during retirement, while only 3.5 per cent believe they will have more than enough money to sustain their lifestyle.

Record-low interest rates also mean the returns of many lower risk investments are substantially less when compared with previous years. While advisers could simply place their clients into riskier, higher-growth assets to address the income gap, this means exposing client capital to potentially low or negative returns during the early stages of the withdrawal period (i.e. the dreaded ‘sequencing risk’).

Following the global financial crisis, some clients are also more reluctant to take on growth assets in their portfolio.

Achieving the right balance between protecting client capital and generating an adequate level of income for retirees has consequently never been more important for advisers.

The Actuaries Institute believes a government review of regulatory arrangements around retirement income products and means testing is necessary to reduce both sequencing and longevity risk and to ensure that Australians have sufficient income for retirement.

In a recent Budget submission, the institute argued the government should look at removing legislative barriers to the development of post-retirement income stream products.

The Association of Superannuation Funds of Australia (ASFA) holds a similar view, arguing the government needs to reassess the tax treatment of certain retirement income products and review the types of asset applicable to the age pension income test.

Despite the legislative limitations, the growing pool of wealth in the retirement space has generated significant demand for retirement income products. This, in turn, has led to a greater number and variety of products entering the market, as well as further development of existing products.

Selecting the products that will work effectively as part of a broader retirement strategy that considers the personal circumstances of an individual and their appetite for risk, however, remains a complex task for advisers.

In exploring the area of retirement income, ifa conducted a survey of its readership, investigating adviser perspectives on the risks impacting retirement income, the various products on the market and how they construct portfolios.

The survey received 229 completed responses, with 38 per cent of respondents specialising in retiree advice. Retirees also form at least 50 per cent of the client base for 41.2 per cent of all advisers in the survey.

The results indicate that advisers consider account-based pensions to be the top product, with 71.6 per cent of advisers in the survey listing this as their favourite product for protecting client capital.

This was followed by income-protected products at 10.9 per cent then equity income products at 9.2 per cent.

The annuities debate

While the recommendation of annuities may not be as widespread among advisers as the use of other products like account-based pensions and income-protected products, they can be an effective tool in reducing the overall longevity and sequencing risk of the portfolio, according to Challenger’s head of technical services, Nathalie Bouquet.

Ms Bouquet says the main advantage of annuity products is that the retiree is guaranteed to receive a certain level of income at regular intervals, regardless of market conditions, for either a set term or the remainder of their life if it is a lifetime annuity.

The ifa retirement income survey found that of those advisers who did not identify annuities among their most preferred retirement income products, a majority listed “low returns” as the key reason they preferred higher risk investments such as account-based pensions and equity income funds.

While annuities do indeed tend to generate comparatively modest returns, Ms Bouquet says advisers should be looking to include them as part of their clients’ overall retirement strategy.

Annuities, she believes, are particularly effective for retirees who are relying on either the age pension or part age pension – as 81 per cent currently do.

Annuities can be used to secure a layer of income above the age pension, allowing retirees to meet their basic income needs for the rest of their life and invest the remainder of their capital in a product like an account-based pension.

While Towers Watson managing director Andrew Boal agrees that annuities play an important role in addressing longevity and sequencing risk, he believes deferred lifetime annuities (DLAs) would offer retirees a better option when compared with existing annuities on the market. At present, there are no DLAs offered on the Australian market, however, since their tax treatment is currently unfavourable.

Mr Boal says retirees have to sacrifice a large amount of capital in purchasing an annuity, which he believes is a significant deterrent for retirees. Deferred lifetime annuities, however, require a much smaller proportion of capital.

“At age 65 you might only have to give up 10 per cent of your retirement savings to purchase an income stream at age 85,” he says, adding that this would give retirees the flexibility to spend the other 90 per cent of their savings between the ages of 65 and 85.

As there is no income being drawn from the product during the deferral period, the tax-free exemption does not apply to the DLA.

Life insurance products are also required to have a surrender value, so if an individual wants to surrender the policy they get the value back.

Mr Boal believes this surrender value should not apply to DLAs and that retirees should instead be required to let the policy run its course following a 90-day cooling off period.

“If they make it to age 85 then they receive the income, and if they don’t make it to age 85 then those premiums will be used to fund the longevity of other retirees,” he says.

While the government has announced it will review current barriers to the development of DLAs as part of a broader review of regulatory arrangements for retirement income streams, it is yet to make any decisions.

CommInsure and Challenger have both indicated they would consider developing a deferred lifetime annuity product if the current regulation was to change.

Despite these regulatory limitations, however, both companies have made considerable progress in recent years in addressing some of the concerns that have traditionally prevented the purchase of annuities by increasing the flexibility and benefits of their products.

For example, both CommInsure and Challenger have introduced a withdrawal period, or guaranteed period, to combat retiree reluctance to lock away access to their capital when they purchase an annuity.

In terms of lifetime annuities, this period generally lasts around 15 years and enables retirees to withdraw the funds from their annuity during this time if they wish to end their investment.

However, the withdrawal value for some annuities can be less than the amount originally invested since it takes into account the payments already received by the retiree up to the point of withdrawal.

Ms Bouquet says the withdrawal period gives investors flexibility so that “if something changes and they need their capital, they’re able to have that”.

CommInsure’s general manager, superannuation and investments, Greg Ballard says the withdrawal period is certainly something advisers and clients need to consider in the “trade-off between the security and how long their capital is locked up”.

Many annuities also offer retirees the option to elect a reversionary beneficiary who will continue to receive payments in the event of the retiree’s death, during the withdrawal period.

According to the product disclosure statements for both CommInsure’s and Challenger’s annuities, if the annuity has been purchased with superannuation assets, the retiree may only be able to select their spouse as the beneficiary.

Some annuities also offer the choice of a full or partial indexation option to protect against the effects of inflation, which can impact the value of a retiree’s income.

Mr Ballard says it is important advisers “clearly articulate to clients the guarantees built into annuity products”.

The role of managed funds

While defensive assets such as annuities play an important role in generating income stability, constructing a portfolio entirely with low-risk products can be just as detrimental to retirement savings as an overexposure to high-risk assets.

Perpetual senior portfolio specialist Adam Curtis says that while a focus on risk is important for advisers, an overly defensive portfolio lacking in growth assets or drivers of returns may actually introduce the risk of having too many low returns.

If these returns are insufficient in producing an adequate level of income, clients will draw down further on their capital, exposing them to the risk of running out of money. Mr Curtis explains that an investor transferring their money from an equity, which may provide them with an income yield of six or seven per cent, to a government bond paying them a yield of around three per cent, could halve their income.

The ifa retirement income survey revealed a large proportion of advisers are generally constructing portfolios with a very high allocation to defensive assets, and with 46.2 per cent allocating 80 to 90 per cent of client assets to defensive assets.

Mr Curtis said while it is difficult to recommend what an exact allocation to growth and defensive assets should be at any one point in the cycle, an allocation in this range could “risk underperforming in long-term investment objectives” – especially with interest rates currently at historical lows.

According to Mr Curtis, many of Perpetual’s diversified strategies, which attract a large proportion of people in or approaching retirement, currently have an allocation of around 70 per cent to defensive assets and 30 per cent to growth.

He believes the best way to address the dilemma of being able to generate adequate income while minimising risk is to have a “genuinely diversified portfolio that reduces reliance on any one particular asset at any one point in time”.

Advisers, he says, ultimately have two main ways in which to achieve this. One option is to perform the task individually, looking at a range of exposures across private markets, infrastructure, private debt and publicly traded securities, ensuring assets are purchased at good prices and complement each other within a portfolio.

Alternatively, they can look at using strategies or managed funds to introduce this diversification into a portfolio.

According to Mr Curtis, Perpetual’s range of funds, from its conservative growth fund through to its diversified real return fund, generally uses a wide variety of strategies and a mix of equity and debt.

Being aware of asset prices and opportunities in the market is also an important part of managing risk, he says.

“Advisers need to be quite dynamic in being prepared to take the exposures when they’re rewarded for risk, and be prepared to reduce exposures when they are actually being penalised for it,” he says.

Consequently, when it comes to selecting a managed fund, he believes advisers should be looking for those using an active, absolute return strategy as opposed to funds that are benchmark-aware.

If advisers are looking to manage equity risk, they should also consider funds that use long-short strategies or more variable beta strategies in a technical sense.

Mr Curtis also recommends short-term income funds and diversified fixed-income funds in terms of managing interest rate risk.

Like Perpetual, Zurich has also developed several products tailored to the retirement market. Zurich has converted a product originally developed for high net worth individuals and modified it to a retirement income product: the Zurich Equity Income Fund.

The fund uses a buy and write strategy, also known as a covered call strategy, which essentially allows retirees to “rent out their shares” to someone with an option to buy them at a price roughly above that of the stock.

Zurich Investment specialist James Holt says this strategy allows the retiree to receive a premium for renting and selling their shares on top of the dividends they’ve received, thus boosting their income.

“In addition, it will very substantially reduce downside market risk; it will participate in the upmarket, but it’ll really reduce the risk when markets decline,” says Mr Holt.

Zurich has also developed a global version of the fund, the Zurich Global Equity Fund, which functions in much the same way but with an exposure to global equities.

Mitigating the risk

The results of the ifa survey indicate longevity risk is a dominant concern for advisers, with 62.4 per cent of all respondents stating they consider longevity risk to be the greatest risk to retirement income.

This was followed by sequencing risk, nominated by 15.3 per cent.

Advisers also raised significant concerns about the combined effects of longevity and sequencing risk on client capital.

Patron Financial Advice general manager Rob McCann says the difficulty in planning for longevity is that while the client may only live to the average life expectancy, they could also live well beyond it.

“Planning is all about leaving nothing to chance, and I think if I was dealing with a client who had assets building, I think I’d be plotting an age that maybe goes a bit beyond the life expectancy, depending on the age of the person,” he says.

Performa Financial Services adviser John Volling says longevity risk is an even more significant issue if the client is retiring on a low asset base.

“Some people are retiring still with debt; that is a huge challenge for them,” says Mr Volling. “Whatever savings they’ve got in superannuation are sometimes used to remove that debt before they can consider what type of income they require.”

Low interest rates were also listed as a major obstacle to achieving an adequate level of retirement income in some of the commentary received in the survey.

Finance Risk Consultants director Goran Gorgievski says low interest rates are a significant impediment to finding products that will generate a decent income.

In addressing this problem, Mr Gorgievski generally uses a combination of annuities and the age pension to form a base income for the client and an account-based pension to generate additional income on top of that.

He also believes client portfolios need a degree of flexibility.

“You wouldn’t want to tie up a large proportion of funds in a particular investment such as an annuity, for example, where there is flexibility but not the level of flexibility of, say, an allocated pension,” he says. “What we might do is structure it in a way where there is flexibility and there is liquidity for the client, so that if something does happen, they have access to capital quickly.”

Both Mr Volling and Mr Gorgievski believe consideration of the client’s individual circumstances in the construction of a portfolio is vital.

“I think you’ve got to carefully consider what the client’s needs are [and] balance that up with a risk and return evaluation,” says Mr Volling. “It’s more important really to ensure that their income stream is going to last their lifetime. Quite often that means using up part of your capital, so that depends on their estate planning wishes and requirements for other expenditure needs such as travelling overseas – really it’s an individual assessment for each client.”

Mr Volling uses a multi-manager, multi-asset class approach in the construction of his client’s portfolio, and then adds in subtler investments, such as bonds or high yielding shares.

“It’s all balanced up with a strict calculation on standard deviation and what we see as the risk element involved in the portfolio,” he says.

Mr McCann also endorses the use of a diversified strategy, stating that it can ensure the portfolio “can handle the bumps as you go along”.

In terms of the retirement income products on the market, however, adviser views are mixed.

Some, like John Volling, believe there are already more than enough products to suit the retirement income needs of retirees.

“I think we’ve got a plethora of choices in the market at the moment – any more products would probably confuse it more,” he says.

Mr Gorgievski on the other hand believes there is a definite need for a wider range of income products offering a consistent income stream with minimal impact on capital.

In the ifa survey, 34.1 per cent of advisers said they would like to see more equity income products, while another 32.8 per cent said they would like to see a larger range of annuities.

However, all advisers and those involved in the retirement income industry agree that any individual approaching or in retirement should be receiving financial advice.

“I think it’s important people do see an adviser – there are so many issues around superannuation and income streams and social security benefits and how they come together,” says Mr Volling.

“To drift into retirement and not have some sort of professional advice means they could very well be missing out on benefits they would already be getting,” he says.

Mr McCann says providing retirement income can make you a “hero or villain depending on the mix of products for the portfolio that you construct for a retiree”.

“It’s a great place to work,” he says, “but at the same time you have to be extremely diligent in what you initially put together for a client and how you monitor and manage that going forward.”

This article first appeared in the April 2014 edition of ifa magazine

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