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3 key principles of retirement income--part one

Anthony Serhan  |  29 Jun 2017Text size  Decrease  Increase  |  
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The Australian government's proposed structural response to retirement income and longevity risk has pros and cons, writes Anthony Serhan, Morningstar's managing director research strategy, Asia-Pacific, in the first part of a two-article series.


The way financial regulation and industry evolve to serve the growing number of Australians facing retirement has huge social and economic implications. They make the government's consultation paper, Development of the Framework for Comprehensive Income Products for Retirement (CIPR), an incredibly important step. We applaud this paper, and the opportunity it provides for Australia to have the retirement income discussion.

It is this sort of process that has created a system the envy of many countries. I am certain that elements of whatever comes out of this process will also be world-leading and have an impact far beyond our shores.

With all that said, I admit to being annoyed the first time I started reading it, because of the overly negative way account-based pensions were portrayed, and what felt like rose-coloured glasses being applied to longevity insurance.

Although a lot of relevant detail and context comes out later in the document, I believe the narrative and industry debate has been too heavily skewed towards product-based solutions. There is a lot more groundwork that can be laid to improve retirement outcomes before jumping straight to a product.

I do not profess to have a complete solution, but there are three broad principles that need to be embraced as part of this process: mechanics, technology, and preferences.

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1) Mechanics

As a research house, we are constantly trying to cut through the noise and marketing to understand what really makes an investment tick. When it comes to retirement incomes, the amount available is determined by four main areas: contributions plus investment earnings, minus fees and taxes (the traditional components of defined contribution or account-based solutions). Adding longevity insurance of some form adds a fifth element--mortality credits.

We believe that the CIPR should be defined as a solution that utilises relevant account-based and longevity insurance component products, as opposed to a composite product. We support the move to make longevity insurance more readily available. However, it is already a complicated product, and adding to this by incorporating additional elements or features will make it more difficult to compare these products and may prevent the formation of a competitive market.

Importantly, while the components of a CIPR may be kept separate, the resultant payout profiles can still be communicated as a combined income stream to members.

The idea that CIPRs will lead to higher levels of retirement income for all Australians, an idea promulgated several times in the paper, oversimplifies the situation and risks misinterpretation. Very simply, longevity insurance transfers assets between those who die early to those who die later. This will clearly benefit some and has the potential to add certainty to many more.

However, the mortality credits created have some implications relative to a simple account-based pension, including:

  • product cost structures will be higher due to the additional complexity,
  • the capital costs associated with longevity products,
  • assets are likely to be allocated to lower-risk and return investments due to the capital requirements placed on annuity providers, and
  • higher distribution or sales costs due to the additional complexity of the product.

It's true in a narrow sense that products such as annuities can create additional income for retirees as long as they live, but this does not always equate to more utility for the retiree. Further, for retirees who wish to draw down a low percentage of their assets, have other sources of income, or are not concerned about longevity risk, a similar improvement could also be achieved through asset-based pensions with the assistance of better advice tools.

Read the second and final instalment of this article on Monday next week (3 July,2017).

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Anthony Serhan is Morningstar's managing director of research strategy Asia Pacific.

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