The secrets of Yin and Yang
Advisers can adapt a combination of retirement income strategies such as probability-based or safety first, depending on clients' needs, Aaron Minney writes.
Opposing philosophies can be complementary
Retirement is different. Financial advisers understand that generating an income stream for a client in the drawdown phase requires a different approach to that used to accumulate wealth up to the point of retirement.
While there are various strategies for retirement income, a recent research report considers that they can be classified into one of two basic approaches:
- Probability-based, based on asset allocation; or
- Safety-first, such as income-layering.
The report, ‘The Yin and Yang of Retirement Income Philosophies1, makes the case that these different approaches can be complementary, like Yin and Yang in Chinese philosophy, and that most retirement income strategies are a combination of both.
The table below is an overview of the Yin and Yang of retirement income philosophies.
Table 1 – Retirement Income Philosophies
|
Probability-based |
Safety-first |
|
|
How are goals prioritised? |
Retirees have a particular lifestyle goal in mind and not meeting this overall goal indicates failure. Lifestyle goals are not prioritised between essentials and discretionary. |
Goals are prioritised across various needs and wants. For example: |
|
What is the investment approach? |
Usually a total returns perspective framed in the same terms as pre-retirement accumulation. The focus is wealth management for the financial portfolio. |
Asset-liability matching. Assets are matched to goals so that risk levels are comparable. Lifetime spending potential over uncertain horizon is the focus, not maximising wealth. |
|
What is the role for guaranteed products like annuities? |
Guarantees are not deemed necessary so the probability-based retiree will not want to pay for them. |
Guaranteed income streams are ideal for providing the safety element of a retirement plan. |
|
How would an account-based income stream be used? |
The standard building block of any probability-based approach, with asset mix selected pursuant to risk- profiling. |
The account-based income stream should be used after the desired safety measures have been implemented. |
Probability-based approach
The probability-based school of thought is often familiar to people in its guise as the, purportedly, ‘safe withdrawal rate' (SWR).
That is, what percentage of assets can be ‘safely' drawn as income each year, such that super will last until a pre-determined age, perhaps life expectancy or an arbitrary age of say, 90.
In Australia, this rule of thumb is three to four per cent for a balanced portfolio. As a retiree approaches their imagined retirement age, they determine whether they can live on the SWR as applied to their asset base. If not, they keep working and saving.
With SWR or any probability-based approach, the starting point is asset allocation, and this is often defined in retirement in the same way as during the accumulation phase.
An attempt is made to mix low and negatively correlated assets within the retirement portfolio to produce the highest expected, or probable, risk-adjusted return.
Spending needs are only relevant in so far as income produced by the SWR will either meet them, or not. They do not determine the asset allocation or the SWR.
Safety-first approach
Advocates of the safety-first approach prioritise income objectives as the essential input to portfolio construction.
Retirees' spending priorities are formed like a pyramid. Essential income needs are the first priority, followed by a contingency fund, followed by funds for discretionary expenses, and finally a legacy fund for estate planning.
Building a retirement strategy requires working up the pyramid to make sure each goal is securely funded before continuing to the next level.
There is no consideration of discretionary expenses until essential liabilities are matched with secure cash flows from secure assets.
The general view of safety-first advocates is that there is no such thing as a safe withdrawal rate from a volatile portfolio, which is further complicated by not knowing how long the money needs to last.
Retirees only have one shot at getting sustainable cash flows from their savings. This means they must develop a strategy that will at least meet their needs, no matter how long they live.
Ensuring client alignment
To relate effectively to retiree clients, advisers can build a flexible process based on client interviews and risk profiling that recognises where the client is comfortable in the spectrum of retirement income choices.
Having the tools to suit the needs of clients who are at different points on the spectrum will give advisers the ability to service a greater number of retiree clients.
While neither a probability-based nor a safety-first approach is definitively right or wrong, different people will align more easily with one or the other.
Advisers who understand both sides of the discussion will be better placed to deliver successful retirement income outcomes (see figure 1).
Case study: Safety-first through an income layer
Maria is a 65-year-old widow with $300,000 in superannuation. She has two children, who work overseas, and would like to travel and visit grandchildren while she can.
She expects to spend around $45,000 a year, including the travel. As she gets older and travel becomes more difficult, she would like to sustain at least $26,000 a year in spending.
Using the probability-based approach, Maria could invest in a balanced account-based pension.
By drawing just under nine per cent ($27,000) of Maria's super balance on top of her part Age Pension, she can expect to spend $45,000 a year until she is 82.
From that time onwards she will be reliant on the full Age Pension of only $22,365 a year (in today's dollars).
In Maria's case this may mean that she would not enjoy the standard of living in her middle to later retirement years that she had anticipated.
By contrast, a safety-first approach for Maria would lock in her essential needs by generating a secure income for the difference between the maximum Age Pension of $22,365 and that desired level of $45,000.
If Maria was to place 30 per cent of her superannuation, $90,000 into a lifetime annuity with partial indexation, she could ensure that she would be able to meet expenses beyond her essential expenses of $26,000 for the rest of her life.
In her early retirement years, Maria would combine the part Age Pension, the annuity payments and just over $22,000 from her account-based pension to meet her desired $45,000 a year.
Taking the safety-first approach would mean Maria would have lower capital in her account-based pension (and a year or two less travel) but she would have certainty over her minimum level of income throughout her lifetime.
Importantly, in contrast to the probability approach, when her account-based pension has run down, she would still have an income layer above the Age Pension, meaning that she would enjoy the standard of living she wants throughout retirement.
Aaron Minney is head of retirement income research at Challenger.
Footnote
1. This article is based on the report ‘The Yin and Yang of Retirement Income Philosophies', by Wade D Pfau, Professor of Retirement Income at American College in Pennsylvania and, Jeremy Cooper, Chairman, Retirement Income at Challenger.
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