Australian issues under consideration apply throughout the world
It is becoming routine to quote Nobel Prize Winner Bill Sharpe saying that decumulation (determining how much you can regularly and sustainably withdraw from your pension pot) is “the hardest, nastiest problem in finance.” From a finance perspective, it’s so difficult because there are two huge and separate uncertainties involved: how long you will live, and what return you will earn on the pot’s assets. Each causes great uncertainty; and yet we have to cope with both. Then, add to those questions the negative psychological effects of the uncertainty, like confusion and stress and fear of running out of money, and we typically become unwilling to deal with the issue at all, simply running away from it.
On the positive side, we’ve found a reasonable approach for helping people with accumulating a pension pot, that is, setting aside money and deciding how to invest it. It’s a much simpler issue than decumulation. With accumulation there’s still the uncertainty of how large future investment returns will be. But the time horizon is less unforgiving in its impact. Not only do we typically we have some ability to control its end date (retirement), but also if we postpone its end date the money tends to keep on growing anyway. And we can even keep the investments going after we retire. So, all in all, the impact isn’t determined by a single date. The reasonable solution is to create what has become known as an investment glide path, for which the investment goal is to give growth-seeking investments time to grow (and time also to reverse temporary declines in value), reducing the growth exposure as we draw nearer to the prospective retirement date (after which there is still, of course, usually lots of time available for the hoped-for recovery if the risk of a sudden investment decline occurs).
This approach has become so popular that it is frequently offered as the default option with pension accumulation plans, and worldwide roughly 90% of participants go with this default. It saves them the trouble of having to think about it, which very few would be able to do, partly because most of us are not sufficiently financially literate, and also because typically we’re dealing with a relatively small portion of the cash flows that our day-to-day financial lives deal with: we’re dealing with new savings each year in the order of 5-15% of our paychecks.
Now, compare that with the issues involved in decumulation. While the time horizon for accumulation is known within perhaps a few years, the time horizon for decumulation has a very much larger margin of uncertainty – it might be very near and it might be more than 30 years away. That magnifies the effect of investment uncertainty – and indeed after a male reaches age 75, or a female reaches age 80, the financial uncertainty caused by the unknown longevity horizon exceeds the financial uncertainty that comes from investing 100% of our assets in a growth portfolio. (Note to myself: write a blog post explaining this.)
No wonder the unfortunate rule of thumb has developed that the only way to ensure that the pension pot doesn’t expire before you expire is never to touch its capital at all – simply live on the income. You can see this actually happen, Australian statistics showing that typically estates at death are almost as large as the initial pension pot at retirement. Or, to say the same thing in a different way, people tend to spend only half as much money from pension pot withdrawals as they would if the pot were converted to a guaranteed lifetime income. What a waste of the huge efforts over the decades to get people to build up a pension pot!
And that brings me to the reason for this blog post.
Australia’s “superannuation guarantee” (SG) system started in 1992, with essentially compulsory savings accumulating in individual accounts, which are then available from age 65. (As you might guess, I’m grossly over-simplifying, but it doesn’t change the point of the story.) Total SG assets now exceed $(A)3 trillion.
As in the rest of the world, Baby Boomers started to reach age 65 some 10 years ago, and are now retiring in very large numbers. But, by and large, they have no idea about what to do with their pension pots (expressed more gently on page 17 of the official Retirement Income Review submitted to the Australian government in July 2020). This too is the position in the rest of the world: no clue about what’s a sensible rate at which to withdraw the money. The Australian government is commendably taking the lead, and is planning to make trustees of super funds offer guidance to their members about decumulation, starting on July 1, 2022.
Problem solved? Hell, no! That’s because, as I understand it, the government appears at this point to be emphasizing member choice and downplaying default options. Given that default options are not only the norm, but indeed the popular norm, for accumulation, surely the need for default options for decumulation are needed even more strongly. I’m not saying that creating default options will be easy – far from it, it will be much more difficult than for accumulation, for reasons I’ll explain – but telling members “we’re giving you choices, but beyond that you’re on your own, and we wish you the best of luck” hardly seems constructive.
What sorts of choices would be useful? Well, choices are needed at two levels.
The first and most basic level has nothing to do with the financial technicalities; it simply deals with a member’s attitude. As I expressed the choices in Walk 2 of my Life Two book, this might be:
- Do it for me; in other words, assign a default option to me.
- Do it with me; in other words, help me to combine my own knowledge (of my situation and my goals) with your technical expertise. In turn, this could involve another choice:
- Once you know more about me, assign an option to me.
- Once you explain the options to me, I’ll make the choice myself.
- I’ll do it myself. And in turn that could mean either of these:
- Refer me to a financial planner.
- I’m capable of doing everything on my own.
I understand that in Australia there are also members who are totally disengaged, and do not respond to anything related to their SG assets – special provisions will need to apply to them.
That’s the first level of choices. The second level is the more technical one of actually having explicit default options.
Why do I suggest options (using the plural) rather than a single option? Because it isn’t possible for a single approach to suit everyone – otherwise “the hardest, nastiest problem in finance” would have been solved by now.
What are the complexities that make this so difficult? Partly it’s because there are those two separate issues to deal with that I mentioned at the start, uncertain investment returns and uncertain longevity. But there’s another fundamental dimension, and that is to accommodate multiple goals that members probably have.
What’s more, members’ SG assets are usually only one part of their total assets. They may have a home, other physical assets, other investments, bank accounts, and so on. It’s a plan for the aggregate assets that’s really needed, and what to do with the SG assets needs to fit in with the overall plan. And the plan may need to be for the member alone, or for the member and partner as a couple, in which case two sets of assets and joint assets need to be included.
Those multiple goals I referred to could include, for example:
- How do your plans for your own lifestyle interact with your bequest motives?
- How much of your SG assets do you need to finance your own lifestyle?
- Are there certain aspects of your lifestyle that you absolutely want to lock in for as long as you live, with total certainty, to enable you to sleep at night?
There are other relevant questions, as you can imagine, but those are enough to show that there isn’t going to be a one-size-fits-all solution.
Elsewhere I have outlined approaches that separate the bequest motive from the lifestyle motive, and then show how the relevant choices vary depending on the “wealth zone” of the member (a comparison of total assets, including government and work-related pensions, with what is required to support the desired lifestyle). Others, like my erstwhile colleague Dr Geoff Warren, have gone further and shown how to accommodate a breakdown of the desired lifestyle between “needs” and “wants”.
So there’s enough material to give trustees a lot of background as they search for (or even design) products and services that reflect the different member situations. And two erudite scholars, Dave Bell and Geoff Warren, discuss some of these issues more fully in an Australian context, at this link.
By the way, there’s a superb discussion of many of the issues in this blog post contained on pages 431-462 of the Australian Retirement Income Review I referred to earlier, for those readers who want to dive very deeply into them.
To conclude: one big thing seems to me to stand out in all of this. It’s not enough to identify products and services (and financial planners) and list them. It’s also not enough if these lists are given to members with some explanations about how to use them. It is absolutely essential to ask members about their attitudes, in other words, the first set of bullets above. And to have a default option specified for each of the various combinations of sets of answers to questions in the (possibly extended) second set of bullets, so that those members who say “Do it for me” can be assigned to the relevant default option. Given the discussion earlier, I’m certain that many retirees will want a default either to be assigned to them or to be guided towards.
I haven’t any doubt that we’ll learn from experience and see which attitudes and which sets of circumstances dominate, and which new products and services become available, so that trustees can refine the choices they offer. That’s inevitable, and all to the good. But default options are an essential part of the solution.
It’s time to create default decumulation solutions
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.