Retirement 12/10 – Innovation could turn trickle into stream

Australia needs to move away from dependence on lump sum superannuation payouts and into retirement income streams.Kieran Dellexamines how new products can help drive this shift.

The retirement income stream market is no stranger to innovation.

An easy example is the innovation of the allocated pension by a small number of fund managers in the late 1980s and early 1990s, which has driven the phenomenal growth in this market in the 1990s.

The total market for retirement income streams has grown from $13 billion in 1996 to $35 billion currently. However, the real success story has been the allocated pension, and its later-born cousin, the allocated annuity, having grown from a standing start in the late 1980s to now account for over 71 per cent of the retirement income streams market, or $25 billion.

By contrast the other main category of retirement income streams, guaranteed annuities and pensions, has lagged behind. Long term guaranteed income streams in particular, have been less popular with Australian retirees despite these streams having been around for many years.

Even with a brief surge in late 1998 as a result of changes to the social security rules, they remain a relatively small part of the market, totalling about 29 per cent at March of this year.

The passionate arguments of the pioneers of allocated pensions in the early 1990s as the Australian Retirement Income Streams Association (ARISA) worked to have these products legitimised in legislation are still well remembered.

There was dismay at the lack of progress in turning us from a nation of lump-sum devotees to one where retirement income is second nature.

The pioneers argued that the introduction of the allocated pension was simply a stepping stone to changing the mindset of Australians towards creating income in retirement rather than just lump sums.

But now that we have taken that first step, how do we take the next steps? How do we increase the 25-30 per cent of superannuation lump sums currently being converted to retirement income streams to a more acceptable level?

The key lies in meeting the needs of retirees better, and this means an increased focus on product innovation.

While the RIS market is still experiencing impressive growth, there has been a notable lack of product innovation in the past few years, although this has not been for lack of trying.

What is frustrating the bid to better meet the needs of retirees, and convince them that these products are appropriate for them in retirement, is the current complex regulatory environment in which income streams operate.

Comparing the regulatory environment of the late 1980s, when allocated pensions first flourished, to that of 2000 produces a stark difference.

Ten years ago there were very few rules covering retirement income streams.

This meant regulators made up the rules on the run. This allowed innovative organisations to take advantage of some of the gaps in regulation to meet the needs of their customers.

Today, we have a more regulated system, which is in part due to the increased importance of this market as well as the hard work of various organisations over the past decade.

As a result the range of product anomalies has been reduced considerably or in some cases eliminated altogether. At the same time the improved social security system for income streams now rewards those who choose longer term income streams over shorter term, capital accessible products.

While it is undeniable that the regulation of retirement income streams is far advanced from the situation 10 years ago, there has been the unfortunate side effect of stifling product development.

With the exception of the development of life expectancy income streams, that were developed in 1998 to meet the new complying income stream rules, there has been little true product innovation in recent times. And in that case it simply involved extending the terms of existing products rather than generating a different type of product altogether.

A useful place to start to find what retirees want is to understand why allocated retirement income streams are so popular.

They offer attractive features, including:

- variable income from year to year as chosen by the retiree, within set limits.

- ability to commute part or all of the capital at any time

- access to potentially higher returning growth investments, and hence the ability to stretch their income payments over a longer time

- a visible account balance

However, the downside of allocated income streams, the possibility that the money may run out early, is yet to be really tested. Given the relative youth of these products, any such problem will only come to the fore sometime down the track.

Guaranteed income streams, on the other hand, offer retirees certainty of income over a particular set period of time, including lifetime. However, the major resistance among many retirees to these products is the lack of product flexibility, including the lack of exposure to growth investments.

This would hardly have been considered a problem as recently as 10 years ago when interest rates were noticeably higher than current levels. But in the days of increased ownership of shares by individuals, being restricted to fixed-interest style investments only within a retirement product is seen as too restrictive. And rightly so, given our longer life expectancies, and hence the need to invest for growth.

The other feature of all retirement income streams that is often forgotten is their sheer convenience. The deduction of income tax, after taking into account any deductions and rebates, means that they provide a simple transition for many retirees from their regular pre-retirement pay packet.

Therefore ARISA sees there beingtwo major issues for retirees:

- The lack of flexibility in guaranteed income streams, including the lack of exposure to growth investments, and

- The inability of retirees without adequate superannuation support to access allocated style retirement income streams.

One response to the lack of flexibility in guaranteed retirement income streams will be to simply mix and match the different types of retirement income streams available to produce the desired "averaged" result for the client.

While this appears satisfactory on the surface, it can create a number of unsatisfactory results behind the scenes. Not only can this approach increase costs for investors, but it also generally increases the complexity of their portfolios and hence the chance of making a serious error along the way.

A better solution here would involve amending some of the tests currently applied to complying income streams. This could allow providers to use a wider range of investments, representing a more diversified portfolio, provided there was sufficient flexibility allowed in setting the level of income from year to year.

While ARISA understands that a complying income stream cannot have the full flexibility of an allocated income stream, we believe that another regulatory stepping stone is needed here to further encourage Australian retirees to use income streams over lump sums.

We believe this important second step can be achieved by allowing product providers to back complying income streams with a wider range of investments.

Such a product would allow the annual income to vary from year to year within modified guidelines, while retaining the elements of payment over life or life expectancy as well as a prohibition on commutation.

This would provide a much-needed boost to product innovation and competition within the complying income stream market. Importantly, such a change would also benefit the public purse in the long term. By increasing the long term investment returns of retirees, and hence the level of income they receive over their retirement years, the level of Government outlays would consequently decrease over time.

The other problem area raised is in relation to non-superannuation assets.

Currently, those who have accumulated assets outside the superannuation system, and cannot get them into the superannuation system, are restricted in the type of retirement income stream they can purchase.

While the full range of guaranteed income streams are generally available outside superannuation, legislation does not allow an allocated income stream to be purchased with non-superannuation monies.

Therefore, the management benefits and convenience of allocated income streams, particularly the "tax-paid" nature of the income stream payments, are not available. In addition, non-superannuation investments in retirement income streams are generally restricted to fixed-interest style investments.

Again, the benefits of an allocated income stream can be replicated by advisers with the use of portfolio services which manage the income of their client via a cash account. However, this is still not as inherently simple as an all-inclusive product which deducts tax on a regular basis, and hence replicates the pre-retirement regular pay-packet of most retirees.

And in this complex world, simplicity and convenience are the keys to success.

While the changes touched on above are only part of the solution to encourage increased use of retirement income streams, it is clear that some simple changes to the rules would greatly improve potential product innovation. It would also ensure that as an industry, we can build a range of simple and convenient income stream products that meet the changing needs of all retirees into the future and possibly even improve the Government's long term financial position.

<I>Kieren Dell is the chief executive officer of the Australian Retirement Income Streams Association.