With few people having access to financial advice, this is a challenge for the system. So we need to make DC pension plans as simple as the old Defined Benefit (DB) plans, with a comprehensive default offering that requires no member decisions, at least until they are sufficiently engaged to take them.
My proposal is that the Australian super funds adopt a liability driven investment strategy which is equivalent to the way an insurer hedges an annuity contract or the way pension funds hedge their liabilities for future pension payments to members. In this case, however, the liability is the standard of living in retirement that the members owe to themselves.
Dynamically adjusted allocations
Essentially, the task is to increase member savings during accumulation and manage income uncertainty, using long-term, duration-matched, inflation-linked bonds as the risk-free component, before and during their disbursement phase.
The allocation of the portfolio between risk-free and risky assets would be dynamically adjusted based on each member’s age, projected future contributions and “funding ratio”. This last term measures the member’s assets divided by their liabilities – the assets being the income their lump sum payment buys and the liabilities being their target income goal.
The funded ratio is critical because it provides a single number immediate measure of how close members are to their retirement goal.
A traditional fund that focuses on maximizing account balances within risk constraints will use short-term fixed income securities as a hedge. But if the goal is to convert a portfolio into an income stream, holding short-term bonds actually increases risk and has low expected returns.
Under the next-gen solution, each member would still receive a sum of money in retirement and still have the same choices about their savings that they have now. The difference is that the value of the pot would be obtained through a strategy intended to maximize the probability of achieving the desired income stream.
Three simple questions
Moving to this income-focused strategy would require changes not only in how super funds invest their members’ money, but also in how they engage and communicate with savers.
Instead of being asked complex questions about asset allocation, engaged members would be asked three simple questions: their retirement income goal, how much they can contribute from their current income, and how long they plan to work.
Once these variables are known, the fund only has to regularly communicate to the member the capitalization rate to progress towards the designated objective and the probability of achieving it. To increase this probability, the fund member has only three choices: save more, work longer or take more risks.
The answers to the three questions for default members would be deducted from their age, salary level and default contribution rate.
Members who engage should have access to a decision-making tool that offers only meaningful choices based on what they already know, and without having to acquire financial knowledge. The solution allows for a smooth transition from the accumulation phase to the payout phase, personalized to retirement.
Above all, we want to build optionality into the system by giving them flexibility in their withdrawal choices.
In addition to saving more, working longer or taking more risks, members could be offered a fourth choice. This option, particularly important for Australia where most people’s wealth is tied to housing, is to generate more profit from their existing assets by using reverse mortgages or downsizing the family home.
As for the “extreme risk” of living much longer than expected in retirement, there is the option of adding a deferred annuity which only pays after age 85, although in Australia the means-tested old-age pension probably meets this need.
As no member is average, super funds will need to customize the retirement income solution across a range of measures. If the member is not up to it, he needs meaningful information and concrete choices.
Above all, we want to build optionality into the system by giving them flexibility in their withdrawal choices.
Thus, there are four major options in the draw phase that the trustees of the super fund can use as components for members to mix and match the mixes according to their needs and circumstances.
The first is a guaranteed income for life, delivered through a traditional annuity, the old age pension or the now rare defined benefit scheme. This may be the optimal solution for someone who does not have a bequest motive or an urgent need for cash.
Second, a conservative withdrawal plan, built around government bonds. This provides secure income and covers bequest and cash requirements, but the member sacrifices the longevity protection of the annuity and its additional income from the “mortality dividend”.
The third option, as set out above, aims for a retirement income goal supported by asset allocation to manage retirement income risk using robust, scalable and inexpensive. The allowance should make efficient use of all dedicated retirement assets, including housing.
The fourth option, which can complement the others, is longevity insurance through a deferred life annuity taken out at retirement and whose payments begin at age 85. In concrete terms, a means-tested old-age pension could meet this need for longevity protection.
Meeting the retirement income framework of maximizing retirement income, managing relevant risks such as inflation and market risk, and preserving flexibility to access savings will require a combination of all of these tools. .
Robert Merton is professor emeritus of finance at MIT’s Sloan School of Management and professor emeritus at Harvard University. He was awarded the Nobel Prize in Economics in 1997 for developing a new method to determine the value of derivatives. He is a resident scholar at Dimensional Holdings Inc.
