It’s striking that how to decumulate – how to organise savings for income in retirement – is a hot topic right now in many countries. Why aren’t solutions ready?
There has been much activity on this issue across the private and public sectors recently. In October 2015, The Challenge of Longevity Risk: Making Retirement Income Last a Lifetime was published by the professional bodies for actuaries in Australia, the UK and US. The New Zealand Society of Actuaries published a report on the same issue a few months earlier (I was a co-author). These two actuarial reports ask one question from four different perspectives.
The question, paraphrased, is How can people best organise their retirement savings for income in later life? There other good questions such as where the savings came from, whether the savings are enough to meet spending needs and what is really meant by retirement. But the focus here is on how to use the savings in pensions pots that people have earmarked for retirement.
This question is being asked with such intensity in all of these countries as the generation retiring about now has more defined contribution (DC) pension saving than has previously been the case. These baby boomers have to manage and bear inflation and investment risks to a greater extent than the previous generation whose pension, if any, was more likely to be in defined benefit (DB) form.
The DB to DC shift is especially problematic as lifespans keep getting surprisingly longer. DB income lasts a lifetime without the individual having to worry about it, but with DC the impact of longevity risk lies with the individual. This risk particularly exercises actuaries who can calculate how likely it is that the income you would like to take from your pot of savings will run out before you die.
The desirable elements of a solution to the income-from-savings question are widely agreed. NEST in the UK and the Financial System Inquiry in Australia promote solutions comprised of different elements to achieve a mix of income characteristics. Here is a similar version (developed from this Robert Merton HBR article):
- A basic level of guaranteed lifetime income is usually provided by the state pension, but may need to be topped up from savings if the state pension is low.
- A conservatively invested ‘safe’ fund doubles as emergency spending and a source of low, perhaps variable, income.
- A potentially higher-return/higher-risk fund, depending on age, can provide regular income by following a drawdown schedule.
- Guaranteed lifetime income (additional to the first element) could come from a longevity protection product such as an annuity as an alternative to all or part of the third element.
A solution combining these many virtues – certainty of income, liquidity, investment diversity, inflation protection, longevity protection, flexibility – would be excellent indeed. But it isn’t possible to point to a working model solution with all these virtues which can be copied around the world. In part, this is because the consumer decision in different markets is affected by market conditions and, crucially, state pension and taxation considerations:
- UK: The market is still unsettled following the unexpected end of the requirement for most people with private pensions to buy a lifetime annuity. Drawdown products are available but as yet not well used. As any income taken from age 55 is taxed at the individual’s marginal rate of income tax each year, while funds left invested in a pension pot are tax-advantaged, tax planning should be an important factor in any decision of how to take income.
- US: The market is more mixed, with different types of DC products and complex tax rules affecting retirement choices. The US has the largest range of decumulation products available for the retirement phase, including more exotic variations on the annuity theme. However, it seems more popular to manage for income using a drawdown plan or on a do-it-yourself basis.
- Australia: Annuities comprise around 5 per cent of the decumulation market. Australians can take their DC pension savings largely tax-free after age 60 as a lump sum or as income. Roughly, half take cash and generally spend it; the other half keep a pension fund account from which to draw down income. Australians may make their choices with one eye on the means test for the basic state pension.
- New Zealand: There are no annuity providers at present. The New Zealand DC savings market is younger than the developed markets elsewhere, so decumulation options are less pressing. KiwiSaver products mostly have a drawdown facility so there is no requirement to do anything at age 65, when all KiwiSaver money is available free of tax. Of all the countries considered here, New Zealand provides the highest and most universal state pension, with no means-testing or qualification by contribution history, so there is less pressure for market options for guaranteed lifetime income.
The other reason why no settled model solution exists is that, as the actuaries’ report shows, “freedom and choice” underpins each country’s approach to using retirement savings. That is, the individual is free to make his/her own choices on what to do with his/her retirement savings. This is appropriate in that individuals have different income needs, risk preferences and amounts of pension savings – circumstances vary in ways which matter to what the best solution might be.
As a result, in all four countries, the answer to the retirement income question will not just be about products. A more difficult version of the question will have to be faced: How can people be helped to make their choices, and manage their money throughout retirement, especially if product choices are limited or opaque, financial literacy is low and savings pots are small?
Answers involving more education, rules of thumb, new types of advice and default settings are all being considered. My guess is that, much as we have to learn from one another, the differences between markets will mean that countries will eventually settle to different answers.