In New Zealand the Ministry of Business, Innovation and Employment (MBIE) is currently reviewing the Default Option for KiwiSaver and the Retirement Commission is undertaking its three-yearly review of Retirement Income Polices.
In this regard, a recent Paper by the Brookings Institute is of interest.
The Paper compares the different retirement policy settings of a number of countries and the growing array of new investment solutions that target the delivery of retirement income. The Papers title: From saving to spending: A proposal to convert retirement account balances into automatic and flexible income has some interesting insights. (The Brookings Institution is a nonprofit public policy organization based in Washington, DC. Their mission is to conduct in-depth research that leads to new ideas for solving problems facing society at the local, national and global level.)
Retirement Income Products
The shift from defined benefit pension plans to defined contribution plans makes it even more important for individuals to save for their own retirement. See my previous Post on the looming Savings Crisis.
The gravity of the problem is well presented in a recent nationwide poll in the USA highlighted by Brookings, 73 percent of Americans said they do not have the financial skills to manage their money in retirement.
Converting retirement savings balances into a stream of retirement income is one of the most difficult financial decisions that households need to make.
Encouragingly, new financial products offer people alternative ways to receive retirement income.
New and innovative financial products are disrupting traditional approaches. The new approaches combine existing products in new and different ways. While they do not always provide guaranteed lifetime income, the innovations nevertheless can give savers options and features that annuities do not provide. They are offering Flexicurity.
The Brookings paper explores non-annuity retirement savings options, but not after first providing a good discussion around annuities, highlighting the benefits, drawbacks, and behavioural attitudes towards annuities.
The paper looks at retirement investment solutions beyond annuities. To do this they provide a good comparison of the traditional approach versus a Goals-Based Investment approach (safety-first).
As they outline, there are two fundamentally different approaches to thinking about retirement income that might be viewed as defining the opposite ends of the spectrum of preferences.
- There are “probability-based” approaches. This approach has goals similar to those of the accumulation phase in seeking to maximize risk-adjusted returns from the total portfolio in accordance with modern portfolio theory (MPT). “Probability-based retirees tend not to base their retirement planning on a distinction between essential needs and discretionary wants, but instead look at ways to meet their total budget. Their investment portfolio during retirement balances market risk against the probability that the money will run out prematurely. This usually requires a high concentration of equities”
- By contrast, there is the “safety-first” approach. This approach engages in asset-liability matching, or financing different income uses with different assets. For example, consumption of necessities would be financed from an annuity or largely riskless portfolio, while less essential goals could be financed with higher-risk investments. “This school tends to believe that retirees must develop a strategy that will at least meet their essential needs (as opposed to desires or preferences), no matter how long they live or how their investments perform.”
I would sit in the safety-first approach. I would complement the Goals-Based approach with longevity annuities so as to manage longevity risk*. This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.
It is also consistent with the Paradigm shift occurring within the global wealth management industry, as outlined in a previous Post, and with the drive to increased Customisation (EDHEC-Whitepaper-JOIM) as promoted by EDHEC.
A very recent example of the innovation occurring is covered in my last Post that outlines the collaboration of BlackRock and Microsoft to develop a technology platform that will provide digital financial-planning tools and new BlackRock funds offering retirement income to employees through their workplace saving plans.
The Brookings paper also provides an example of the ongoing innovation within the industry. The paper provides a good discussion on Managed Pay-out Funds.
Managed Pay-out Funds, which are a major alternative to an annuity, are designed to produce a relatively consistent level of annual income but that does not guarantee that outcome.
They are similar in some respects to Target Date Funds (TDFs) but have a different objective. A well designed TDF would sit in the second category above and would make a good investment solution for a Default KiwiSaver Option.
Managed pay-out funds serve as decumulation (Pay-out) vehicles, paying monthly or quarterly cash distributions to retirees.
The goal is stable income pay-outs stemming from consistent investment returns, and possibly growth, over time rather than maximum gains. The annual income amounts are calculated using both investment performance and, in the case of many managed pay-out funds, a gradual distribution of the principal amount invested in the fund.
Unlike many annuities, these managed pay-out funds are also flexible enough to allow retirees to revise their decisions as circumstances change.
Some of these Funds are the extensions of TDF where the investment strategy shifts from accumulation to income (Pay-out).
Brookings also make the observation that Defined contribution (DC) plans, such as KiwiSaver, will not fulfil their potential to deliver retirement security until they include an automatic mechanism that efficiently helps participants to convert retirement savings into income. “Experience has demonstrated that most new retirees who are handed a lump sum are ill equipped to understand and successfully navigate the many complex risks, trade-offs, and necessary decisions.”
New Zealand can learn from other countries experiences. Particularly the learning that a greater focus should be placed on the generation of retirement income late in the accumulation phase.
Significant improvements can be made to retirement solutions by better positioning portfolios to generate a steady and stable stream of income in retirement.
This should be undertaken in the late stage of the accumulation stage and not left until one reaches retirement.
As outlined in a previous Post this is consistent with what the OECD encourages: the retirement objective is to be the generation of income in retirement and for there to be coherency between the accumulation and pay-out phase of retirement.
Currently most investment products are poorly positioned to meet these objectives.
The retirement investment solution needs to be customised to the individual and there needs to be a greater focus on generating a sufficient and stable stream of replacement income in retirement (Pay-check).
This highlights the ongoing need for investment solution innovation in New Zealand.
As Brookings note: “What ever the solution, one thing is clear: Retirees need innovative solutions that help them make the best use of their savings as they transition to a new phase of life.”
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Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.
* By way of explanation, a longevity annuity provides protection against outliving your money late in life. This type of annuity requires you to wait until you reach age 80 or so to begin receiving a pay-out.