Market volatility raises question of longevity risk

The recent volatility seen in global stockmarkets raises one important issue that Australia has overlooked, says ISN’s Chief Economist Sacha Vidler – How to effectively manage longevity risk in our superannuation savings system.

In recent weeks, measures of stock market volatility have hit peaks seen previously only in the midst of the global financial crisis. Very few of us gain from the gut-wrenching swings that such volatility brings, but (surprisingly) some do.

Once again, revenues are roaring for online stockbrokers (who had been lamenting the relative stability of global markets in the last few months of the 2011 financial year), because while prices have dropped, trading volumes have soared to terrific levels.

Another tiny group who thrive in tumultuous times are the economic commentariat who gain a captive audience – of retirement savers, mortgaged families and underemployed youth – for their ruminations about the workings of capital markets beyond anyone’s control, and seemingly even the experts’ understanding.

This time around, the commentariat even became the story as debate (politely) raged over whether Westpac’s Bill Evans was ahead of the pack or lost in the wilderness for predicting an imminent downturn in economic activity – and therefore interest rates.

But then, we economists can’t not write about it, can we?

Managing longevity risk

Increased market volatility highlights important issues in superannuation policy – notably, the one area of superannuation policy untouched by the suite of reviews currently drawing to a conclusion: the retirement phase.

Ripoll, Henry and Cooper have looked at financial advice, contributions, tax, data standards, e-commerce, multiple accounts and default funds, but not the retirement phase – and particularly the question of whether retirees currently face excessive investment and longevity risk.

Investment risks – already top of mind due to market volatility – have been put in the spotlight by a prominent industry identity, former Future Fund CEO Paul Costello, who questioned the appropriateness for retirees of the Australian asset allocation model with its high allocation to growth assets.

Longevity risk is the risk of outliving your money, and is clearly important as the population continues to age. There is an important gender dimension to longevity risks, because women on average live longer and have less super savings with which to generate retirement income.

Longevity risk is addressed through provision of income for life (and the life of the spouse).  For most Australians, the only coverage for longevity risk is from the public Age Pension. Individuals who hope for a higher standard of living than that provided by the public pension bear the remainder of that risk.

There is no policy incentive (such as more generous tax or pension means-test treatment) for retirees to invest in income products which manage investment or longevity risks, even though there is a case for a public interest in a sharing of this risk between the state and the individual.  And current regulations mean that longevity risk products such as traditional life annuities can only be offered by a Life Office, not your superannuation fund, with investment and accounting rules ensuring very low effective rates of return.

Traditional life annuities also have other disadvantages, including that the pricing is set at the moment of purchase, with some retirees doing far better than others out of this instant capital crystallisation.

ISN is currently researching a product offered in several jurisdictions overseas in which fund members would bear investment and longevity risks – but collectively rather than individually.  Assets held include some growth assets, though typically at less than 50 per cent, and investment returns are smoothed over time according to objective and transparent rules.

Payments are made for life at a level influenced by the mortality of the pool of members.  There usually isn’t explicitly indexation in such products but inclusion of some risky assets will tend to provide a natural hedge against inflation.
We will also be looking at the policy obstacles, if any, to the introduction of such a product in Australia.

The Australian superannuation system is something to be proud of, but it is a notable oversight that none of the powerful tools that shape the system in the accumulation phase – mandates, incentives and defaults – are employed in the retirement phase. In time, this will need to be addressed.

For further information, contact Sacha Vidler at svidler@industrysuper.com

Message from the Chief Executive

Australia’s superannuation system is unique and is often upheld as one of the most successful retirement savings models in the world. In light of recent global market events, however, we need to do more to protect members’ savings, including increasing our engagement with the global financial services industry, says ISN Chief Executive David Whiteley.

In July 2011, David delivered a special address to Sydney’s prestigious Lowy Institute on this topic. The following editorial has been adapted from this address.

Taking a global approach to protecting super members’ savings

Superannuation is one of Australia’s great economic and public policy achievements. In just under two decades, it has helped Australians save more than $1.3 trillion for their retirement and this is estimated to almost triple to $3.2 trillion by 2022.

Superannuation has become much more than a retirement savings vehicle. During the global financial crisis (GFC), Australia’s superannuation system acted as a critical pool of capital in the economy. It provided liquidity and bolstered confidence, asserting itself as an important macroeconomic stabiliser.

However, for many, the global financial services industry (of which our super system is a part) was seen as part of the problem rather than the solution.

The evolution of the financial services industry from being a service to businesses and consumers, to an industry that generates considerable profits from its own activities on financial markets, was identified as one of the causes of the GFC.

Ultimately, poor regulation and risk management in conjunction with the mis-selling of sub-prime mortgages led to the financial crisis, which has had such a detrimental effect on economies, jobs, investment markets and, of course, investment returns.

From the domestic perspective, the 2009 Johnson report on the Australian Financial Centre Forum found that Australia’s regulatory system was adequately balanced between what can be competing objectives, for example, consumer protection and product innovation. The report noted that the general view of market participants is clearly that some of the excesses that led to the GFC were not replicated in the Australian context.

This is largely true, and in my view one reason for Australia’s relative strength has been the increasingly active role played by super funds to improve the application of governance in listed companies, as well as the engagement with listed companies and fund managers. As part of this process, fund managers themselves have developed an understanding of what expectations super funds have of market behaviour.

Nonetheless, the inter-connectedness of global financial markets meant that this strength did not insulate Australians completely from all economic stress, nor did it protect us from the considerably negative effect on our savings and investments.

Collaboration and engagement on a global level

The next step is to commence a dialogue about how the Australian super industry can engage with the global financial services industry to better protect the wealth of our members. This means reducing the volatility caused by speculation, and recognising that there is a role for super and pension funds to influence the behaviour of market participants. It also means acknowledging that regulation is not always able to keep up with what might politely be called ‘innovation’ by sections of the financial services industry.

Global pension funds account for an estimated $28 trillion in assets. Geographically they span Europe, Asia, North and South America. While their structure and governance arrangements vary, their interests are aligned to meet their obligations to fund the retirement incomes of working people.

In dollar terms, their clout significantly eclipses mutual funds, insurance, real estate, hedge funds and private equity funds. With this in mind, it seems extraordinary they haven’t been more influential than they have been to date.

I believe that there is the potential for funds to be more assertive about which investment practices are acceptable for funds managers to engage in at any level – and to avoid the tail wagging the dog.

An obvious initial collaboration could occur with US and Canadian pension funds. As well as being among some of the largest internationally, they have perhaps the best linkages to the large US-based fund managers that operate globally.

Jack Bogle (head of Vanguard) commented that, “We’ve become a financial economy which has overwhelmed the productive economy to the detriment of investors and the detriment of our society.”

In Australia, industry super funds are clearly aware of our role in the economy and the obligations and opportunities we have when investing our members’ retirement savings. In particular, we seek to invest in the real economy, in businesses, jobs, infrastructure, and in the future.

In doing so, we recognise that our own sector is evolving and that we have a responsibility as guardians of our members’ savings to ensure that our own industry practices are sustainable and productive. It is this philosophy which super funds can extend to initiate successful engagement with the global funds management industry.

David Whiteley

Financial pressures influence retirement decisions

Many people drawing down on their super are yet to retire from the workforce and describe their current income as only ‘modest’ or ‘tight’. This makes financial pressure a significant influence on decision-making at retirement for some super fund members, according to a new ISN study.

Research commissioned by ISN found investment in pension products is not the norm among retiring industry fund members, with plans for their retirement savings dominated by motivations such as debt repayment, lifestyle choices and immediate financial needs. This contrasts with households reporting higher levels of retirement savings, which are much more likely to allocate savings to pension products.

Awareness of the existence of pension products is also low, but increases with retirement savings levels. Even survey respondents claiming to be familiar with a range of investment products had fairly low levels of awareness about pension products.

While most retirees have no debt, a significant group of retirees and near-retirees has debt levels which will substantially eat into their retirement savings. Around 20% of survey respondents have debt worth more than half the value of their retirement savings.

Retirement decision-making for this group requires consideration of options including delaying retirement and paying debt using retirement savings or the sale of the current home or other assets. Click here to read the report.

New research shows why superannuation must be lifted to 12%

A major new report on retirement intentions by industry super funds shows why the superannuation guarantee must be lifted from its current rate of 9% of wages to the more sustainable figure of 12%, as the Federal Government has proposed.

The research ‘Retirement Savings and Longevity’ by Dr Sacha Vidler found that more than one third of retirees said they only had enough superannuation savings to make ends meet or actually had insufficient superannuation to make ends meet.

Around half of those drawing on their super are continuing to work – suggesting their super is not adequate for them to live on.

The report found that a significant proportion of payouts are used for short-term consumption or paying off debt. It found that at most retirees devote only 40% of their accumulation to income stream (allocated pension) products – a finding at odds with the Federal Treasury who this year provided modeling to the Government which assumes a 100% take up of income stream products.

Commenting on the findings, Industry Super Network CEO David Whiteley today said that the focus of many retires on short term consumption such as “around Australia” driving holidays was not unreasonable and not unlike what teenagers do when they have a gap year after finishing school.  

‘We can’t mandate how people spend their super, but there are important implications. With many people tending to spend a big proportion in short term consumption, adequacy needs to be up to scratch to ensure there is enough left over to supplement income in the many years of retirement that lie ahead – it illustrates why increasing the super guarantee to 12% is a good idea.”

‘It is not up to Government or anyone else to tell retirees how they should spend their super savings.  It is their money and they are perfectly entitled to realise some of their dreams while their health allows.’

‘But it is important that there is enough super left over to provide a decent income in the years ahead.’

‘This is precisely why lifting super contributions from 9 to 12 percent is necessary. This way, Australians can live a little when they retire and still have solid savings to fa fall back on.”

Retirement Intentions and Longevity

A major new report ‘Retirement Savings and Longevity’ by ISN Chief Economist Dr Sacha Vidler  found that more than one third of retirees said they only had enough superannuation savings to make ends meet or actually had insufficient superannuation to make ends meet.