Is there an alternative to drawing the minimum legislated rate in Account-Based Pensions? Rein van Rooyen discusses a new paper which investigates how alternatives may affect pensioner welfare.

In Australia, the majority of people retire with lump sum benefits from defined contribution superannuation schemes and elect to take their benefits in the form of Account-Based Pensions (ABPs).  Determining the appropriate drawdown from assets in retirement is a complicated and important problem faced by many older Australians.  That complexity and importance mean that preparation of comprehensive, independent advice covering retirement drawdown is desirable for the majority who do not have the financial literacy to navigate the decisions themselves.  Advice is often expensive and not a feasible option for everyone.

The Rule of Thumb (ROT) working group, which consists of John De Ravin, Estelle Liu, myself, Paul Scully and Shang Wu, presented the paper ‘Spend your decennial age’ at the Actuaries Summit[1] to address this issue in the absence of advice.  The paper addresses the needs of retirees who are entitled to full or part pension, and who usually do not commission comprehensive, independent advice on drawdowns, but rely on other inputs, such as the ABP minimum withdrawal rates covering pension assets.

The purpose of the paper was to develop some ABP drawdown rules and investigate how alternative drawdown rules affect pensioner welfare as determined by using a utility metric, taking into account the lifetime interactions with the Age Pension means tests for different asset balances.  The ROT working group used the legislated ABP minimum drawdown rates as a starting point and explored some previously published drawdown rules. Then, using the results of dynamic programming calculations that produce optimum drawdown rates by age and asset balance, the working group developed three new drawdown rules, including a simple rule of thumb, that yield improved total lifetime utility of consumption for retirees.

### Spending decisions in retirement – current Australian environment

When members of a superannuation fund attain a “condition of release”, they are able to withdraw their funds from the superannuation environment or to shift their accumulation account balance into a pension phase.  For the time being, the pension product environment in Australia is considered under-developed.  Currently the great majority of those who convert their accumulation balances to a pension phase, use their balances to purchase an ABP, which is effectively a pension product where the pensioner has control over both asset allocation and the rate at which the pension is “drawn down”, subject only to statutory minimum withdrawal rates specified in the Superannuation Industry (Supervision) (“SIS”) legislation[2].  Those minimum rates are shown in the following Table.

### Table 1: Minimum statutory drawdown or ABPs

 Age Bracket Minimum Drawdown % Below 65 4 65-74 5 75-79 6 80-84 7 85-89 9 90-94 11 95 or older 14

Recognising the under-developed state of pension products in Australia, the Government has proposed the introduction of the “retirement covenant”, which is effectively a requirement for superannuation funds to develop Comprehensive Income Products for Retirement (or CIPR).

The working group acknowledged that the retirement product environment may change with the introduction of the Retirement Covenant and the development of CIPRs.  However, despite the imminence of CIPRs and their potential impacts, the authors believe that the key question of what percentage to draw from ABPs will remain critical for the near to medium future.  The reasons are:

1. It is not yet clear how quickly or enthusiastically superannuation funds will develop or promote their CIPRs;
2. It is not clear to what extent retirees will adopt CIPRs in preference to ABPs;
3. Even if CIPRs are widely taken up, the current expectation is that typically only 25%[3] of such products will be annuitised.  If that is the case, then 75% of a typical CIPR will still require a decision by the retiree as to how much of their ABP component to draw down.

### Drawdown rules

Various drawdown rules have been developed over the years ranging from Bengen’s 4%[4] rule to “spend the income but not the capital” rule often adopted by SMSFs.  Each rule has its own limitations and the biggest challenge from an Australian perspective is that none of these rules allow for the interaction with the age pension entitlements, which forms a significant component of most retirees’ assets in retirement.

The ROT working group developed three rules, namely A, B and C.  The simplest of these is Rule A, which is defined as:

• Baseline drawdown rate % = the first digit of your age;
• Add 2% to the baseline drawdown rate if your account balance is between $250K and$500K (exclusive);
• Subject to the statutory minimum drawdown rule

By way of illustration, the recommended baseline drawdown rate for someone in their 60s would be 6%. If the person has an ABP balance between $250K and$500K, then the recommended drawdown rate would be 8%.

The second rule, Rule B, has been developed for sophisticated retirees and uses a modestly sized two-way lookup table to determine the drawdown rate.  This rule might be used by retirees who are more financially engaged and who are willing to vary their chosen percentage drawdown rate a little more frequently according to their age and asset balance, as per the table below.

### Table 2: Sophisticated retiree rule derived from optimal drawdown ratios

 (%) <=74 75-79 80-84 85-89 90-94 >=95 <=260k 6 8 10 13 15 17 261k-700k 6 10 11 13 15 17 701k-1m 7 8 9 11 13 15 >1m 6 7 8 10 12 15

Ages are banded quinquennially, but no distinction is made between ages below 75, or after age 95.  The working group derived this rule by grouping and averaging the optimal drawdown ratios based on age and balance.

The third rule, Rule C, has been developed for financial advisors and has been derived directly from the optimal drawdown analysis (represented in Table 3 below).  Here age progresses in single years, rather than being grouped quinquennially or decennially, and assets are grouped in $100K bands. ### Table 3: Financial adviser rule derived from optimal drawdown ratios  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 >700K 6 6 6 7 7 7 7 7 7 7 8 8 8 8 9 9 9 9 10 10 10 11 11 12 12 13 13 14 14 601-700K 8 9 9 9 9 9 9 9 10 10 10 10 10 11 11 11 12 12 12 13 13 13 14 14 15 15 16 16 17 501-600K 9 9 9 10 10 10 10 10 10 11 11 11 11 11 12 12 12 13 13 13 14 14 15 15 16 16 17 17 18 401-500K 9 9 9 9 9 9 10 10 10 10 10 11 11 11 11 12 12 12 13 13 14 14 15 15 16 16 17 17 18 301-400K 8 8 8 8 8 8 8 9 9 9 9 10 10 10 10 11 11 12 12 12 13 13 14 14 15 16 16 17 18 201-300K 6 6 6 6 7 7 7 7 7 8 8 8 9 9 9 10 10 11 11 12 12 13 13 14 15 15 16 16 17 <=200K 5 5 5 6 6 6 7 7 7 8 8 9 10 10 11 11 12 13 14 15 16 17 18 19 20 21 22 24 24 The authors have chosen to use a utility framework to assess the drawdown rules instead of using other commonly used measures such as the replacement rate, probability of running out of money, shortfall risk and the funded ratio. This is because the utility framework implemented captures the risk averse nature of retirees, in particular their aversion to asset volatility, as well as the risk of outliving retirement savings (longevity risk) while the more commonly used measures fail to incorporate risk preferences. The Member’s Default Utility Function (MDUF)[5] has been used as the chosen utility framework to assess the drawdown rules as it represents an attempt to quantify a sensible set of preferences for a superannuation fund trustee to assume on behalf of default fund members, on whom the trustees have limited information. ### Conclusion The complexity of individuals’ personal circumstances emphasises the need for financial advice, yet few Australians are willing to pay for such advice. Excellent techniques for computing optimal spending for individuals are available but these are complex and currently not available to individuals. It would seem desirable for individuals to have access to tools into which they could input their own financial and personal data. The ultimate objective would be to enable good advice to be provided at a very modest cost. Although it is not possible to find drawdown rules that are simple and optimal for everyone, the rules that the working group has developed all provide better retirement outcomes for retirees than drawing down at the statutory minimum rate. All the rules developed also respond significantly to the age pension means testing parameters, with recommended drawdown rates being materially higher compared to the minimum statutory rate. There could be several explanations for this phenomenon, for example: (a) that many do not fully grasp the implications of the means tests for current and future consumption; (b) some have a bequest motive; or (c) retirees value factors that are not captured by the consumption utility framework such as maintaining contingency amounts for health costs or aged care, and a preference for flexibility; or (d) the “nudge” effect of the statutory minimum dominates other issues. Above all, the authors believe that the paper has identified that the most widely used reference, the statutory minimum drawdown rules, is generally too low to yield anything close to optimal utility. Individuals would be better advised to spend more, especially in the younger years of retirement. This finding is consistent with previous Australian studies[6]. 1. Bengen, W. (1994). Determining withdrawal rates using historical data. Journal of Financial Planning, 7(4), 171 2. Member’s Default Utility Function (MDUF) is an open-architecture metric to assist the industry to design retirement outcome solutions. The related materials can be accessed through AIST website via http://www.aist.asn.au/policy/member%E2%80%99s-default-utility-function-(mduf).aspx and ASFA website via http://membersdefaultutilityfunction.com.au/ 3. Spicer A, Stavrunova O, and Thorp S (2016). How portfolios evolve after retirement: evidence from Australia. Economic Record, 92 (297), 241-267. And Asher A, Meyricke R, Thorp S, and Wu S (2017). Age pensioner decumulation: Responses to incentives, uncertainty and family need. Australian Journal of Management, 42 (4), 583-607. CPD: Actuaries Institute Members can claim two CPD points for every hour of reading articles on Actuaries Digital. ### Comments ##### JimHennington says 19 July 2019 Hi my name is Joe Satire. I'm 64 and my wife is 59. She has had an incidence of cancer but it seems under control now. We have 300k in super and a$300k investment property we are thinking of selling. We've been told we get 50% of a part age pension when I'm 66 then a full one when she reaches 66. We have disowned one of our children but not the other.

My question is - what does "Optimal Utility" mean?

##### JDR says

23 July 2019

Dear Joe,

Thank you very much for contacting us, Joe. First of all may I pass on the deepest sympathies of myself and the co-authors of "Spend your decennial age" regarding the recent medical issue affecting Mrs Satire (Josephine, if I remember rightly). We are delighted that she is well on the road to recovery.

Joe, I have to acknowledge that your circumstances create a certain number of challenges for the drawdown guidance we have tried to develop. If I didn't know better, I'd almost suspect your circumstances were contrived to create some challenges. But it is true that there will always be specific aspects of people's personal circumstances that mean that no simple drawdown rule can be both "optimal" for everyone's different circumstances. So given your special personal circumstances, we would encourage you to seek advice from a qualified financial planner, or perhaps from the salaried advisers employed by your superannuation fund.

But turning to some of the issues you have raised Joe, firstly I note that you (like the majority of retirees) are a member of a couple. Our paper, for the time being, provides guidance which strictly speaking is only relevant only for singles. Also, you are not yet of an age that entitles you to an age pension, though in two years, as you say, it appears you will be entitled to about 50% of your half of the couple age pension. Our paper hasn't explicitly dealt with the question of couples, especially where the ages are different, and also we make it clear that we are only talking about those who are entitled to the age pension, and your wife will not be entitled to a pension for about another seven years. These issues are not explicitly addressed in our paper - we had to do some pretty challenging math to come up with our rules even for our relatively simple situations, and the extra variables relating to couples would have made our task much harder still!

Your wife has suffered an incidence of cancer, which means that she may live to her normal life expectancy but she may also suffer a recurrence which would place her in some danger of shortened life expectancy. You would need to talk to an adviser about your circumstances but we suspect that the adviser will suggest that for the time being, it is safer to assume that she will have normal expectancy. If at some future date she suffers a recurrence and her life expectancy is impaired, you might decide you can afford to spend a bit more than the amount that would otherwise be appropriate. (But this suggestion is somewhat intuitive in nature rather than being derived from "optimal utility", which would require detailed calculations involving very special mortality assumptions).

Joe you mention an investment property, which is a very significant asset (equal in value to your superannuation balance). The calculations in our paper had to assume that there were no assets outside superannuation - this was to avoid complexities introduced by the assets test, where pension starts to be reduced dramatically once you exceed the lower Assets Test Threshold. Again, this means that the guidance in the paper is not directly relevant to your circumstances. Probably it means that you would be better off spending more than the 6% "first digit of your age" because you will be in the assets zone where your annual age pension (when your wife and you both reach pension age) falls by 7.8% of your assets in excess of the lower Threshold. However, your circumstances are not explicitly addressed by the paper.

Finally Joe I note that you have disowned one of your children. (Was it drugs? Or did the disowned child commence actuarial studies? Or move to New Zealand?). Our paper ignores any explicit bequest motive, though with an Account Based Pension there will always be some level of assets remaining when the pension holder passes away if you follow the guidance in our paper. But if you intend to leave a very specific minimum amount to one of your children, that would also need to be factored into your drawdown decision.

Oh, and finally, yes, "optimal utility". Yes, that's economist-speak, it sounds like mumbo jumbo doesn't it? But take it from me Joe, all we're trying to do is help you have the happiest possible life by helping you intelligently choose the amount you can spend each year - not so much that you will run out of funds to supplement your age pension, nor so little that you can't enjoy the lifestyle that you might like to lead in the meantime. And we've allowed for the fact that an extra dollar when you can't spend much doesn't bring you the same amount of happiness as an extra dollar when you've got lots to spend - you'd agree with that, right Joe? 'Cos it's more important to be able to eat and drink than go on overseas travel junkets!

In summary Joe, the authors acknowledge that many of your circumstances mean that the "spend your decennial age" rule cannot be applied directly in your case. I reckon you need advice. But in the long run, wouldn't it be great if someone could help retirees draw down at the right rate, ALLOWING for all their personal circumstances? That would take a clever computer programme. Maybe one written by an actuary (are you reconsidering disowning your actuary offspring?).

Hey Joe, here's a thought..... Forget your wayward kid, don't you have a very smart mate who's an actuary, and who's really good with all sorts of IT "stuff"? Jim Somebody-or-other? Why not tell him about the challenge you and Josephine face, and get him working on that really smart computer programme that will solve all your problems?

In the meantime Joe, all good wishes to yourself and Jo.

##### Stephen Woods says

18 December 2019

A++ for both of these!

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