What's next in retirement income?

Thought Leadership

What's next in retirement income?

17 May, 2022

As super funds prepare to publish their retirement income strategies to comply with the new Retirement Income Covenant, the next question is what are they going to do differently? What innovations will be available to help members in retirement?

Tom Freston, co-founder of MTV said "Innovation is taking two things that exist and putting them together in a new way". This quote highlights how sometimes a simple innovation can bring a large benefit.

Ways of managing retirement income risks are not mutually exclusive

What we are seeing in the retirement income market is innovation across two components that are called out in the Retirement Income Covenant. Super funds will need to manage investment and longevity risks to maximise retirement income. They also need to provide members with flexibility and help manage the effects of inflation.

Recent product innovations relate to market and longevity risks; with the innovation being that the ways of managing these risks are not mutually exclusive. Historically, the approach to retirement income has involved either a market-based solution, such as an account-based pension, or a guaranteed lifetime annuity. Either the retirement product had exposure to markets, or it removed market risk in retirement. A lifetime annuity was often CPI-linked so it removed the three key retirement risks. These can be effective tools for building a retirement income solution but the retiree, or their financial adviser, would often also want market exposure.

Enabling product innovation

Changes in 2019 opened the door for innovation in retirement income products, and this is now leading to an increased range of options that combine risk management with market exposure. The products now coming to market were not permissible before the changes.

One example is a new retirement option provided directly by a super fund. The product has some of the features of a lifetime annuity. For example, the income will be paid for life, but you don't have access to your capital after a cooling-off period.

This product is invested in a balanced fund so it has exposure to potentially higher market returns, while accepting some market risk, but higher income payments are not guaranteed. To maintain the income payments from year-to-year, the investment returns need to match an assumed average. In good years, the payments will go up, but in poor years the payments will go down. A product like this internalises the management of the risk that some people will live longer than others, but the payment variations should even out over time.

A second risk is that everyone in the product lives longer than expected. This second risk cannot be effectively managed and will, all other things being equal, result in lower income payments. The result is a product that includes exposure to markets ups and downs and an opportunity for higher returns while providing an expected income for life.

The rule changes also enabled another product innovation, linked to the traditional guaranteed lifetime annuity. Like the super product in the previous example, this provides exposure over time to market returns, but it has a stronger protection against longevity risks. Tracking underlying market returns is the only factor that will impact the payments. Different index-linked income options give greater flexibility to the retiree (and their adviser) and this innovation makes it easier to maintain the desired market exposure. A conservative investor can match their desired risk profile with the lifetime income stream and the account-based pension used for drawdowns. Options can be adjusted annually throughout retirement as risk profiles change.

There are other innovations in the mix that will help advisers and retirees manage market risk, including a product that builds in protection from sequencing risk that can be present in an equity portfolio. Other innovations under development will combine market and longevity risk management in different ways.

These recent developments build on the innovations we saw following the 2019 changes. The first adjustment was annuity products that defer income payments many years into the future. Waiting for longer to get some of your money back might sound odd, but the cost of this insurance is a lot lower because a smaller amount can be invested in this product. This can help some older Australians manage their retirement in a way that wasn't possible only a few years ago.

The key point is that choosing a retirement income is no longer an either/or decision. The Retirement Income Covenant requires super funds to find a balance between maximising expected income and managing longevity and investment risks. However, it is possible to target both at the same time and managing the risks in retirement more effectively can potentially lead to higher retirement income if this is done properly.

"I want my MTV" was an expression that highlighted the consumerism of the 1980s for baby boomers and their families. The latest product innovations provides the opportunity to give the boomers what they want in retirement too.