# Anthony Asher, Associate Professor at the School of Risk and Actuarial Studies at UNSW, writes about the sort of pension product that he would like to see developed now that SIS regulations have been modified to allow development of more flexible products.

On 1 July 2017, the SIS regulations were amended to allow for “innovative income streams”, which allow funds to pool longevity risk with investment freedom – i.e. variable annuities without guarantees. At last, almost 25 years after the original SIS Act, superannuation funds can now develop pension products that address members’ real needs. This article outlines the product I would like someone to develop for my retirement (and which I think would meet the needs of most people).

To start, I’ll assume that neither I, nor my wife, will ever qualify for the Age Pension.  This is partly because the current Age Pension income and asset test rules make it relatively unlikely, but also, I think they should be adapted to ensure it remains unlikely. This means that the design I am suggesting applies mainly to the wealthiest 20% of retirees – those with retirement assets well over $1 million. I also think however that it would be very useful to the least affluent – those below the current Full Age Pension asset test floor of around$250,000 for singles and around $380,000 for couples. (These amounts apply to homeowners, renters are allowed another c.$200,000.) Pensioners not subject to the asset test could increase their regular spending by about 20% by buying an annuity rather than keeping all their assets for a rainy day.

I also say that I do not want to have to manage financial assets during retirement. I will keep some cash and unit trusts as a small buffer, but I want a pooled pension that pays an income that is intended to remain roughly constant for the remainder of our lives (with a reduction of 30% on the first death). I am happy to accept systematic longevity risk (i.e. mortality improves faster than expected) and some investment risk, which will mean payments will vary.

The product thus far described can be relatively easy to design and administer. In the USA, the TIAA CREF (their Unisuper) has offered them for 70 years. All it requires is:

1. A mechanism for mortality pooling: the balances of those who die need to be distributed in some way to those who survive. Testing that the formula is fair and works in all circumstances is a great actuarial exercise. Getting it so that deviations from experience have equal impact at all ages and durations is a bit of a challenge, but not impossible.
2. A mechanism for translating the profits and losses into a change in payment to the member. My strong preference is for the differences between the initial mortality and investment assumptions to emerge over time. If mortality trends lower than expected after allowing for improvements, the payments should slowly reduce from what is expected. I expect my expenditure to decline as I age and would not be too unhappy if a reduced income hurried the process. (Unlike the US, the evidence is that Australians do not seem to face increasing out of pocket medical costs with age and aged care is so subsidised that it is always affordable.) I do not want some company, on the advice of their actuary, to decide that the future has changed and that they should capitalise changes to assumptions so that my income can again be more or less level. This leads to unnecessarily greater volatility.

A big question is how I can trust the company that issues the annuity not to find some way to dial up their revenue once we reach our dotage? The less discretion the better. They must also guarantee their charges (inflation adjustments are OK) and the contract may not allow them to create reserves with my money. Profit shares that are affected by changing inflation or asset mixes are also not wanted.

How to choose investments is more of a problem. The cash flow to come from a life annuity is approximately the reciprocal of one’s life expectancy plus two thirds of the interest rate. For the 30 years’ expectancy of an upper-middle class couple, that gives 3% plus two thirds of the expected return. Investment in risk free real interest will therefore yield about 4% of the capital. In comparison, a share portfolio would yield over 5% in dividends and franking credits – with potential for growth over the long term. On my calculations, dividends reduced by about 30% in the early nineties and again in the GFC but quickly recovered. Thus, in the current market you are very likely to be better off in equities if the current dividend levels persist. Dividends can fall by 20% before you begin to suffer, which I think is a fair risk to take.

A pooled annuity starting at 6% of capital could be funded largely by dividends in earlier years. There is therefore some sense in an investment strategy that gradually shifts assets into lower risk investments (including guaranteed annuities) as pensioners get older. There is however a problem if the share market is low for a decade or more (which is not unlikely on a historical basis).  This is because annuities do require increasing amounts to be disinvested.

There are smoothing solutions that do not involve arbitrary reserves. Australians companies could look at the with-profit annuities available in the UK and South Africa[1]. The record of the former is more realistic given the latter if one has a more pessimistic view of future share returns. Even the Prudential, with its high profit targets has given a (slightly) positive real return over the last ten years with average annual returns of 7% (nominal) for policies started in the early nineties. Some of the new products have no discretions, but do rely on dynamic hedging – which creates something of a systemic risk.

I would prefer to see funds develop innovative capital instruments that match annuity type cash flows from providers and users of capital. The point is that there are many users of capital that would prefer to repay over a period of time. Home mortgages provide the obvious example, but many other borrowers (think infrastructure such as toll roads especially) might prefer to pay over a period. In most cases, these payments could be indexed to inflation. The ideal would be salary inflation – see my paper on Salary Linked Mortgages in the 2011 AAJ.

The author is Convener of the Retirement Income Working Group. The rest of the group may not agree with the opinions expressed in this article. We are, however, currently thinking about potential standards for innovative income streams. All opinions will be considered: let us know yours.

[1] As a start: http://justsa.co.za/media/1064/web-product-brochure-just-lifetime-income-investment-driven-sygnia-final.pdf

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##### gregeinfeld says

8 September 2017

Thanks Antony for the insightful article.

I am looking for something slightly different. I would like to manage my own investments, however would like to take advantage of a mortality pool. Given most of the wealthiest 20% of retirees have SMSFs, I suspect this is a common situation.

How would you see this working?

##### ramani says

8 September 2017

A useful contribution, thank you.
My concern is at a threshold level: despite the fact insurance, which involves pooling and cross-subsidisation has been around for a long time, pensions partaking in pooled mortality have an asymmetric behavioural bias for others subsidising them and against their subsidising others. If I die early why should I help those who live longer, and vice versa.
Not rational, but among the many reasons it has taken super's silver jubilee for us to get talking about it, this aversion might be one factor.
Note somehow in the matter of investments people seem to be more accepting of ups and downs (though if one looks through, some people make money while others lose - barring outright Bernie Madoff scams).
I wonder if the Government that anyway now underwrites mortality risk in respect of unfunded age pensions should 'seed' basic mortality cover, at least upto the prevailing age pension limits? This merely formalises what now is, but might give an overdue fillip to better dealing with longevity.
There are other approaches that might be employed but they are politically unpalatable: review family home exemption from Centrelink; make super a retirement saving not an inheritance for grandkids; institute a stutory reverse mortage scheme for asset rich cash poor seniors. There is poetic equity in government wading into twilight year management, even as it mandates eraly working saving by way of SG.

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