How target benefit plans can help retirees meet their income needs
Petr Kocourek from CFS Global Asset Management explains how target benefit plans tackle the issues faced by defined benefit schemes and defined contribution systems in providing enough income for retirement.
As defined contributed pension schemes are becoming the dominant means of retirement savings around the world, the problems affecting these schemes are becoming apparent globally too.
While Australia’s superannuation funds have had a head-start, questions remain about the effectiveness of many of the superannuation designs in achieving the ultimate goal: assisting participants to save enough for retirement.
That is, after all, the fundamental purpose of any retirement system.
Securing sufficient funds to ensure a comfortable old age income is becoming an increasingly troublesome undertaking.
Defined benefit (DB) schemes are frequently under-funded and under increasing pressure to reduce pension outcomes, whilst defined contribution (DC) funds deliver below-par results.
Although this is mainly due to demographic factors, increasing longevity and disappointing returns, it is clear that especially for defined contribution systems a crucial ingredient is needed, which is the notion of an explicit target outcome.
Target benefit schemes
Shifting the focus to a target outcome introduces relevant measures of risk, as well as highlighting key objectives around asset allocation.
This is especially useful for DC systems, which currently rely primarily on time diversification without appropriate objectives or risk measures.
DB schemes have long had to deal with explicit target retirement outcomes – and many of the tools and techniques developed for DB schemes can be applied fruitfully to DC schemes as well.
The explicit retirement target outcome needs to be stated in terms that are relevant to the members, and roughly translate to having enough money to pay for retirement.
More specifically we can look at this as a “target benefit” to be achieved, which in turn can be expressed as an annuity or as a percentage of average lifetime salary.
By explicitly targeting a level of income after retirement, we can design an investment strategy which, over time, maximises the probability of providing this income stream or its annuity equivalent.
This is where we bridge the gap between defined benefit and defined contribution schemes – hence the moniker “targeted benefit.”
The role of volatility and risk returns
The real and relevant risk a member faces is not volatility, but not having enough money to secure the desired old-age income.
Choosing the appropriate risk/return trade-off is vitally important for the design of a target benefit scheme.
Crucial in this trade-off is the necessity to define and measure the outcomes of the scheme in relevant quantities. Portfolio return and volatility are important, but not necessarily relevant to members.
Instead members want to know how much income they can reasonably generate from their accumulated capital. In order to do this, the value of the accumulated capital is expressed as the capital equivalent of an annuity – as a percentage of latest or average income.
The concept of risk then also becomes clear: it is not volatility around an expected return that matters, but the probability of not accumulating sufficient capital to meet the funding requirement for such an annuity benefit target.
This translates into a notional liability at retirement age.
That is, we view the capital required to purchase an adequate income stream as a future liability that must be funded.
The ability and likelihood of funding this liability depends to a great extent on the investment strategy during the accumulation phase.
In addition, after retirement the risk of the capital running out during the lifetime of the retiree is obviously relevant.
This is where insurance aspects may come into play by using part of the accumulated capital to acquire actual (lifelong) insured annuities.
It is imperative to view the entire span from pre-retirement to post-retirement as a comprehensive whole to maintain consistency and seek optimality.
A target benefit approach addresses the limitations of traditional lifecycle and target date funds through its ability to express the risk and return in terms of annuity equivalents at retirement age.
Instead of targeting accumulated wealth in isolation, such a scheme can target its true objective, which is retirement income.
Achieving the right amount through customised asset allocation
The moment a target is established the pieces start to fall into place.
A target benefit scheme can then optimise for annuity-based retirement targets throughout the lifetime of the members, allowing them with the scheme’s guidance to achieve their objectives with much less overall relevant risk, where the relevant risk is the risk of not having enough capital to buy their desired annuity.
The customisation inherent in such an approach provides members a risk-minimising path to accumulating the required capital that is specific to their circumstances in terms of their human capital, built-up financial capital and time remaining until retirement.
To successfully model a customised scheme we take into account the level of expected contributions and withdrawals, annuity targets at retirement, career salary increases and changing confidence levels required to attain the targets.
Most traditional lifecycle or target date schemes take only age into account in setting the asset allocation without any regard to the individual members’ specific circumstances.
By making the asset allocation a function of more than just age and also including built-up capital, the portfolios of the individual members can be tailored to a much greater degree.
The system needs to be dynamic in order to account for changes in circumstances, such as missing years of contributions due to unemployment or career changes, or even simply by dint of disappointing market returns on the portfolio.
As the situation changes the target benefit system provides the members with guidance along the way to that target.
This is essential to manage the risk of not having enough money for retirement. Of course the target as established within the scheme has to be realistic given the contribution and withdrawal levels.
Target returns versus expected returns
The target return and expected return are very different concepts. In order to achieve a target return with an acceptable probability, the expected return needs to be higher than the target.
If the expected return is the same as the target return, you stand an approximately 50 per cent chance of making the target. In most cases this is not an acceptable outcome.
When you translate this to a targeted annuity at retirement age, the expected annuity should be considerably higher in order to have a high probability of achieving it.
As members age, the scheme’s built-in guidance takes the relevant parameters into account to produce a new risk-minimising portfolio.
The screws are also tightened on the risk that is allowed with respect to the targets as members age; for a 20-year old it may be acceptable to have a 75 per cent confidence level of meeting the intermediate target at age 21, but at age 65 the confidence level has to be much higher.
Having reached the target at retirement age with a sufficiently high probability, the system allows for flexibility in retirement in buying annuities.
The retirees can decide to use all or part of their built-up capital to buy an insured lifelong annuity. This flexibility is important because it allows the retirees to choose how much certainty they are willing to trade for the possibility of additional higher returns.
The options span the gamut from the highest certainty of full annuitisation to the lowest certainty of staying fully invested.
Implementing a target benefit scheme
There are many ways of implementing such a scheme.
For instance, adjustments can be made to traditional target date funds by adding a few more options to account for differing amounts of accumulated capital.
Actual fund members would be invested in a mix of a number of representative portfolios, adjusting for their individual circumstances.
Given enough operational flexibility, the target benefit system could also be implemented in its most extensive form with highly customised portfolios for individual members.
The gap that currently separates DB from DC can be bridged, and the challenges facing superannuation can be conquered but it requires innovative thinking, robust modelling, thorough understanding of the ultimate objectives and risks, and some operational flexibility.
Petr Kocourek is a senior portfolio manager at Colonial First State Global Asset Management.
AUTHOR
Staff Writer
Recommended for you
The financial services technology firm has officially launched its digital advice and education solution for superannuation funds and other industry players.
The ETF provider has flagged a number of developments as it formally enters the superannuation space through a major acquisition.
While all MySuper products successfully passed the latest performance test, trustee-directed products encountered difficulties.
Iress has appointed Insignia Financial’s former general manager of master trust and insurance products as its newest CEO of superannuation, who will take over from Paul Giles.
