Thought Leadership

Retirement covenant trade offs lifetime income streams


13 Oct, 2021

Nearly every decision in life involves balancing trade-offs. The design of a retirement strategy under the Retirement Income Covenant (Covenant) is one which will require careful consideration of complex trade-offs to achieve and balance the objectives of:

- maximising expected retirement income;
- having flexible access to savings; and
- managing risks to sustainability and stability of income, in particular investment risk, inflation risk and longevity risk.

‘Balance’ is a key word as each objective involves a trade-off against the others. A Trustee can consider incorporating a lifetime income stream and an account-based pension (ABP) as a holistic retirement product to balance these objectives. Implementing a lifetime income stream requires an understanding of the key trade-offs between the range of different features that are available to help meet the Covenant objectives.

Lifetime income features - the trade-offs
The Covenant requires a strategy to manage longevity risk. This is the uncertainty around how long a member will live and so how long income needs to last (the period of retirement). A lifetime income stream promises to pay the member an income for life, no matter how long that is. However, the amount of income received can differ and it could vary over time. 
There are four key trade-offs when appropriately including a lifetime income stream in a retirement income strategy.

1. Longevity risk protection: insured vs shared 

There are two forms of protection for a lifetime income stream.

A traditional lifetime income stream makes payments to the member which are guaranteed by a life insurer. The income will be paid no matter how long the member lives, how population mortality changes during their retirement, or how long other investors live. Longevity risk is removed.

An alternative is a lifetime income stream where longevity risk is shared by investors and the amount of income paid might depend on how long other people live. If other investors live longer than originally expected, then payments will be reduced over time. Conversely, if they do not live as long as expected, then payments for survivors will increase over time. Longevity risk is reduced but not completely removed. 

If you are interested in learning more about this trade-off read this article.

2. Maximising a stable and consistent retirement income: immediate or deferred income

A lifetime income stream can provide income immediately, or the income can be deferred and commence payment in a future year. All other things equal, the starting payment for an investment in a deferred income stream will be higher than that of an immediate income stream. Less needs to be invested to achieve the same amount of annual income because there are fewer payments. Although the deferred income stream design has some very attractive and capital efficient characteristics, there are a some very important and less well known trade-offs:

  • A deferred income stream will not pay income to the member for a number of years complicating the drawdown strategy. In the deferral period the ABP will need to provide stable income to the member and could be drawn down quickly, potentially increasing exposure to sequencing risk in this period.
  • An immediate income stream pays income from the start and so less is required to be drawn from the ABP. The drawdown strategy can be simpler due to income from the ABP and lifetime income stream commencing at the same time.

3. Balancing investment and inflation risk: lifetime income exposure

A lifetime income stream can be designed to produce income that, for example, is fixed, inflation-linked, or market-linked. Consideration should be given to how the risk profile of a retirement strategy is constructed when using an ABP and a lifetime income stream.

  • A market-linked lifetime income stream which has income linked to the returns of a diversified portfolio of assets can be considered to have risk characteristics equivalent to those assets. When incorporating a market linked income stream with an account-based pension, it is appropriate to match the risk profile of the market linked income with the risk profile of the ABP.
  • On the other hand, an inflation-linked or fixed (payments never change) income exposure can be considered a defensive investment allocation. Therefore, to achieve a balanced exposure when incorporating a CPI linked or fixed lifetime income stream with an ABP, it would make sense to blend with an ABP with a growth profile. In other words, the CPI linked or fixed lifetime income stream forms part of the defensive allocation of the combined retirement product.  

The three lifetime income streams outlined will balance investment and inflation risk in different ways: 

  • Inflation-linked income exposure will provide income that increases with inflation and pay a stable real income for life for the member.
  • Fixed income exposure will provide a stable income that will decline in real terms over time and therefore requires the ABP to manage inflation risk.
  • A market-linked income exposure is expected to grow income in real terms over time. This is not guaranteed, and even matching inflation depends on the underlying investment performance. Under high inflation, or poor market performance, income can fall in real terms. Income will move up and down with market returns and, on its own, is unlikely provide a stable real income.

4. Flexible access to savings: purchasing lifetime income upfront or over time

The level of flexibility required to access lump sums by a target member cohort is an important factor in determining the mix of lifetime income stream and ABP within the holistic retirement solution. Consideration should be given to the level of savings net of debt (e.g. mortgage) of a target member cohort.

To manage flexible access to savings, a lifetime income stream can be funded in different ways:

  • The established approach is the upfront allocation to a lifetime income stream e.g. invest 20% of savings at retirement. With only 60% of the investment counted as assessable assets, this can increase Age Pension entitlements for assets-tested members at the start of retirement. The draw down from the ABP can be reduced in this situation.
  • Another approach is to spread the investment over multiple years, more akin to an insurance arrangement, to reduce timing risk. E.g. invest 2% p.a. into a lifetime income stream each year over 10 years. However, the longer the purchase period the lower the potential Age Pension increase for the member.
  • Alternatively, the lifetime income stream could be funded during accumulation phase by setting aside a member’s “excess returns” into a personalised defined benefit allocation that starts to pay a lifetime income stream at retirement to complement the ABP.

Balancing trade-offs
Modelling a range of strategies incorporating an ABP and lifetime income stream will assist trustees assess which features of a lifetime income stream will achieve the objectives of the Covenant for their members.

A quantitative modelling framework to assess when, and if, a lifetime income stream could help achieve retirement objectives for a cohort of members was discussed by Challenger in a recent paper