14 Feb The difference for advice in retirement
|There is a wave of activity at present dealing with how Australian retirees manage their savings IN retirement, including the advice they should be receiving. Some, like the Royal Commission, are grabbing headlines, while others such as FASEA’s proposed requirements for advisers, and the development of a new product for the retirement stage of super, are little known beyond industry experts.
One of the key challenges is to meet the needs of the mass of people moving into retirement who will need advice focused on managing their portfolio to fund spending, instead of building up the portfolio value.
SUPER IS WORKING
The Australian super system is now at least 25 years old. While the industry funds kicked off before then with the 1986 Accord Mk VI, it was in 1992 that saving through super became compulsory for employees. This helped the many baby boomers now retiring with a decent super balance. Recent APRA data highlights that many super funds have average retired member balances of over $300,000 (at June 2017). And the average retirement balance will increase further in coming years as subsequent retirees have more time to compound their super contributions.
This creates a fertile environment for advisers who understand the needs of retirees and can relate to them. Projections by ASFA estimate that 40% of retirees will be self-funded by 2025, compared to only 24% in 2010. Figure 1 shows the increase in self-funded retirees and the reducing reliance on the age pension over time. Most will need help in the form of advice to manage (i.e. spend) their retirement savings appropriately.
Figure 1: Trend of decreasing reliance on age pension 2010-2025
Source: 2010 & 2017 – Challenger calculations based on data from ABS, DSS and DVA; 2025 – ASFA Myths that super will come up short, November 2017.
Proposals for super funds to develop Comprehensive Income Products for Retirement (CIPRs) will go some way to lessening the need for advice. Nonetheless, the growth in the number of retirees and the increasing proportion needing advice will underpin growing demand for suitable retirement advice.
THE RETIREMENT CHALLENGE
The goals of a portfolio IN retirement are very different from the goal of saving FOR retirement. In the absence of a regular pay cheque, retirees need their investments to negotiate not just market and inflation risks also present in the accumulation phase, but also risks such as sequencing risk and longevity risk. Few retirees will have saved so much, or spend so little, that the risk management techniques relevant in the accumulation phase will solve all their issues in retirement.
Success or failure of a retirement plan
One of the biggest challenges in providing advice for retirement is the lack of a clear success measure. In accumulating assets, there is one goal: create the largest possible pool of savings. This provides a clear success measure and well-known steps to improve the ultimate outcome, including: asset allocation; saving more; reducing costs; minimising taxes; contributing (working) for longer; right down to the typical competition to get better investment returns. Practitioners are well accustomed to working in this paradigm.
Understanding the rate and direction of retirement spending provides a broad segmentation of retiree goals. In retirement, typically, there are different forms of expenditure to plan for:
Success will often involve meeting all four objectives, making success much more difficult to measure in retirement. Retirement advice also calls for a focus on the lengthy time horizons involved. Retirees who start spending in year 1 of retirement need to know how that is going to affect the availability of income in year 20 and beyond.
The difference for advice in retirement
The predominant focus of advice, historically, has been building wealth for investors during the accumulation phase. Retirement advice has often focused on tax strategies and estate planning. Advice encompassing spendable cash flows, the sustainability of retirement savings, mitigating longevity risk, cognitive decline and aged care has been the exception, rather than the rule.
But a key challenge with many Australians now retiring with significant super balances is that the advice they need is how to spend that over their remaining lifetime. As highlighted in a 2017 National Seniors Australia survey, only a very small minority of older Australians want to leave everything for the next generation.
This is consistent with the approach taken by the government with some of its recent changes to superannuation. The government clearly wants tax-advantaged superannuation wealth to be spent down by retirees, rather than being preserved for the next generation. The $1.6m transfer balance cap is designed to be enough to provide $100,000 a year across an average retirement, but only if all capital is consumed. The age pension taper rate clearly contemplates a reduction in accumulated savings through retirement. As means reduce via spending, support from the government increases through the age pension.
Retirement advice therefore needs to go beyond portfolio management to include advice on managing the required cash flows through retirement. This includes consuming capital to create a higher standard of living for retirees. After all – that’s what super is for!
|Understanding how people spend their money in retirement|
|In putting a plan together with a client to generate income in retirement, time horizon should, of course, affect the substance of the plan. And, with new retirees realistically able to expect to live up to 30 years or more, it’s reasonable that their spending needs will change over time. However, the question of spending profile over time is often avoided or glossed over. It needs to be addressed. Assuming a constant level of real spending is like ignoring the topography of a map – when walking through mountains, the shortest and most direct path is often not a straight line on the map.
A problem with the traditional assumptions
The traditional economic assumption is that people maintain (or, at least, try to maintain) a constant real level of spending throughout their lives. This includes the assumption that spending is constant in real terms throughout retirement. Bengen’s 4% rule explicitly assumes that this is the spending profile.
But there is a big problem with this assumption. It is not what people do.
In retirement, measures of spending point to older retirees spending less than younger retirees. This is sometimes described as the difference between an active stage of retirement and a passive stage of retirement – an additional frail stage when health-related costs increase but most of the other expenses fall away. The pattern is far from an assumed constant, real spending level.
The observed pattern might just reflect that older retirees can see their capital running down and so they reduce their spending. However, it also aligns with the health of older retirees. They might have once been able to enjoy an active lifestyle but eventually slow down as they find themselves unable to enjoy an active lifestyle even if they could still afford it.
So retirees face an economic problem over time. They have limited resources but they still want to get the most out of life. Planning to spend the same level throughout retirement won’t maximise the utility of a retiree whose health deteriorates. They may have the money for golf fees in their 90s but alas, they can’t swing the club like they used to so they won’t enjoy the benefit of their retained money. The preferable option is probably to play more golf as a younger retiree.
Household spending over time
Knowing that an 80-year-old spends less than a 65-year-old today doesn’t necessarily tell us what the 65-year-old will spend in 15 years. There are many other variables that the cross-section misses.
Looking at a longitudinal study such as the HILDA surveys can provide a better picture on the path of household spending over time.¹
Interestingly, spending tracked by the HILDA surveys does not change much over time. Average spending, adjusted for inflation, is broadly constant when households are matched over time. It is also the case that older retirees are spending less than younger retirees.
To clarify, at any time, older retirees are spending less than younger retirees but, over time, retirees maintain their level of spending (in real terms, on the items measured in the HILDA survey).
This is clear evidence of a cohort effect for retirees. In effect, people lock in their lifestyle at the point of retirement. (Anecdotally, you can tell how long someone had been retired by the model of their car they drive in retirement. Upgrading to a new car at the point of retirement and continuing to drive that car, until someone can no longer drive, is a common observation reflecting this lifestyle lock-in.)
Don’t forget about the other spending
Importantly, HILDA doesn’t measure all spending. In fact, if you look only at HILDA, you might conclude that Australian retirees spend less than the age pension. However, there is limited other supporting evidence for this conclusion.
Instead, the data points to age pensioners spending down their savings and not accumulating more. Of course, some wealthy retirees do save more as they can’t spend the income from their lofty savings base. There is not much commentary that the age pension is too generous, with arguments for the government to cut the level of support.
Spending that isn’t measured in HILDA is measured by the Australian Bureau of Statistics (ABS), but it doesn’t track households over time. By linking the two data sources, it becomes clear that not only are older retirees spending less, but they are spending a lower proportion on the expenditure items that are not included in HILDA. This pattern is consistent across years with the pattern for single households in 2015-16 shown in Figure 1. The percentages highlight the proportion of spending outside the HILDA survey.
Source: Constructed by author from HILDA and data supplied by the Australian Bureau of Statistics
Need and Wants
The split between HILDA and the other spending might not be an exact match to retiree desires, but it does highlight two different types of spending.
The first is a level of spending that is maintained across ages and is generally captured by HILDA (the green in Figure 1). Let’s call these ‘needs’. The other spending appears more flexible so let’s call them ‘wants’. Wants tend to fall with age (as seen in Figure 1) and it seems that retirees choose to forego this expenditure while they continue meeting their needs.
This concept of needs and wants seems sensible in the real world. If retirees have two different types on consumption, it makes sense to generate the income to spend on needs and wants in different ways. A good retirement plan should include the flexibility to meet the retiree’s needs and the wants separately. This is what an income layering approach delivers to retirees.
1. HILDA stands for the Household, Income and Labour Dynamics in Australia survey which is funded by the Department of Social Services and managed by the Melbourne Institute. It tracks a panel of Australians over time, capturing – among other variables – spending of key items at the household level.