Overcoming inefficiencies in investment-based retirement income

Former chief actuary of Denmark Per U.K. Linnemann unpacks retirement income inefficiencies and avenues to overcome them.

1. The retirement phase of investment-based retirement income is underdeveloped

It is pointed out in the Retirement Income Covenant Position Paper, published in 2021 by the Australian Government Treasury that, “29 years after the introduction of compulsory superannuation, the retirement phase of superannuation remains under-developed.”

In the USA, some 40 million Americans have put at least part of their retirement money in Target-Date Funds (TDFs) which were introduced in the early 1990s in the USA. And yet TDFs are not designed to convert savings to income.

In Denmark, investment-linked variable income annuities (VIAs) where payments fluctuate with the markets have become prevalent.

The initial income is affected by sudden market swings at retirement and payments are adjusted to underlying investment portfolio performance. Therefore, market volatility will cause retirement income to vary too much from year to year, creating anxiety among retirees and soon-to-be retirees. That is a significant shortcoming.

To reduce the volatility in retirement incomes the investment-linked annuities are combined with lifecycle (TDF-like) investment strategies where the provider gradually reduces the investment risk over time for the customers. This approach with predetermined glidepaths at the fund level is one size fits all and lacks customisation.

The focus is on reducing the volatility of the investment account to reducing the volatility in retirement incomes. In this way, retirees must accept lower expected returns and smaller payments as the price to pay for more stability in retirement incomes.

2. A new approach to investing and spending in retirement: iTDFs

We need a new approach to investing and spending in retirement that can fill the vacuum in investment-based retirement income products internationally.

The so-called individualised Target Date Funds (iTDFs) has been developed to overcome the shortcomings and inefficiencies in investment-based retirement income. They remove the burden for individuals of having to manage both investment and longevity risk.

iTDFs open new perspectives on investment-based retirement income. For example, retirees do not have to accept lower expected returns as the price to pay for more stability in retirement incomes.

On the contrary, the iTDFs’ smoothing mechanism enables the combination of expected higher returns with lower volatility in retirement incomes. The formulae also mitigate the risk that sudden market swings close to the retirement date might have on the beginning income.

3. How does it work?

This new approach to managed payout products is based on personalised dynamic investment strategies and capital-efficiente smoothing of retirement incomes for each individual. It is a desired or default degree of smoothing and investment horizon pre-and post-retirement that determines the level of investment risk profile (e.g. high, medium, low) during accumulation and decumulation.

The full market-linked return is passed on to the investment account of the individual investor during both the accumulation and decumulation periods. Investment risk exposure is reduced as investors get older – avoiding excessive investment risk-taking at old age. Retirees typically have less tolerance and capacity for investment risk as they get older.

Contrary to the old TDFs and VIAs, the new iTDFs approach gives each investor a personalised dynamically self-adjusting glide path. Asset allocations are automatically adjusted between a risky (diversified) investment fund and a less volatile (diversified) investment fund in response to investment market developments and the capacity to take on or limit investment risk (i.e. actuarial funding status of the current level of retirement income). In this way, the balance between assets and future liabilities are being adapted and payments can be smoothed while remaining responsive to financial markets’ performance.

The built-in drawdown and investment strategies adapt automatically and dynamically to each other over time. They are integrated and coordinated by mathematical formulae and constitute a unified whole in an innovative way. The investment strategy supports the income-generation objective to smooth retirement income. 

4. Smooth transition between phases and choice between payment profiles

iTDFs combine the accumulation (saving) and decumulation (income) phases seamlessly, providing both a savings vehicle and a regular smoothed retirement income.

iTDFs may be designed with or without longevity income management and different lengths of a drawdown period before any optional longevity pooling among retirees commences (a life insurance company does not need to be involved). They offer a seamless and smooth transition avoiding a gap and unintentional abrupt changes in the level of retirement income between the drawdown and longevity pooling phases.

Retirees do not have to enter the life-contingent phase. They may opt-out of a previously chosen longevity option at any time during the drawdown phase, e.g. because of deteriorating health. The surviving relatives may inherit the remaining savings in case the participant passes away during the drawdown period.

A choice between smoothed payment profiles can be offered. For instance, income could be weighted towards the first many years of retirement where retirees may prefer higher retirement incomes, when they tend to be more active. Or it could be weighted toward the latter years to help offset the effect of inflation. It can also be achieved that the smoothed retirement incomes are not being adjusted downwards with a high degree of certainty.

5. Filling the vacuum in investment-based retirement income products

One iTDFs flexible framework can provide a platform for the creation of a family of investment strategies and smoothed retirement income products.

These products do not require any guarantees that have to be paid for, and the manufacturer does not have to assume investment and mortality risks.

Different versions of iTDFs can be tailored to local market conditions and purposes and targeted at different groups – including low to medium earners.

Relying on a robust algorithmic framework, iTDFs will fit into an increasingly digitalised and mass-customised world. They can be delivered as fully automated direct-to-consumer solutions. The algorithm-based product design allows scalability, portability, and low cost.

iTDFs may have the potential to benefit millions of retirement savers and retirees around the world. That said, things may take longer to happen than you think they will, and then they happen faster than you thought they could.

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Comments

Image of George Nassios
George Nassios says

30 September 2022

The proposals tabled are a positive step forward for further options to members during the deaccumulation phase. Having worked in areas that need to dynamically manage investments relative to target outcomes you would need stronger risk and quant frameworks ( also potentially risk capital) to achieve the objectives proposed

It is in the implementation of these frameworks and suitable capabilities that I would see as the key drivers for a positive outcome. PS also note dynamic targeting can fail at times because of one off events eg GFC, pandemic etc IE not that easy at times

Image of Per Linnemann
Per Linnemann says

1 October 2022

Thanks for your comment, George. It should be mentioned that methods such as CPPI or OBPI are not used in connection with iTDFs.

Image of David Williams
David Williams says

2 October 2022

Variable income annuities were available in Australia in the nineties but fell at the hurdle of Treasury short-sightedness. The iTDF approach looks really useful in adapting to individual changes over time.
Coupled with that, individuals need support in developing and maintaining their own longevity plan, which harmonises their financial, health and estate planning decisions to provide the best chance of holistic approach to the rest of their life.

Image of Per Linnemann
Per Linnemann says

3 October 2022

Thanks for your comment, David. iTDFs could play an important role as building blocks in a holistic approach to financial planning.

It could be of relevance in relation to the current regulatory environment in Australia to mention that smoothed income iTDFs may be designed alone for the decumulation phase. Moreover, the iTDFs framework can also provide solutions alone for the savings phase offering a smoothed lump sum at retirement. In addition these two separate solutions might be combined.


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