Investing in the Post-Retirement Years

Transcription

1 Investing in the Post-Retirement Years 1. OVERVIEW 1.1 By definition, the sole purpose test in the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act) sets the parameters for the superannuation industry in Australia. 1.2 Superannuation trustees must ensure their fund is maintained solely to provide benefits for members when they retire (or reach age 65) and/or for the members estate or dependants when they die Unfortunately, while most trustees have well-developed processes for investing their members benefits during the peretirement (or accumulation) phase, less attention has been given to the post-retirement phase. 2 Post-retirement income has been labelled as one of the weakest parts of the Australian superannuation system 3 and a market failure. 4 This may not be unexpected. The Australian superannuation guarantee (SG) system is, after all, relatively young. 2. DEFAULT INVESTMENT STRATEGY FOR POST-RETIREMENT Current trend 2.1 Most superannuation funds currently use the same default option for post-retirement products as for those held for preretirement (accumulation) products This may be intentional. Two reasons that trustees take on investment risk for members in retirement are: the existence of the Age Pension, which is a means tested, lifetime annuity indexed to inflation. This effectively provides a defensive asset in retirement (a safety net), so that retirees can take up some risk in retirement; 6 and managing longevity risk requires retirees to earn as much as possible from their investments However, increasing analysis shows that using the same default option for both pre and post-retirement products may not be an optimal strategy for many retired members and that superannuation trustees should look closer at the way they invest the benefits of post-retirement members. 1 The legislation also allows a fund to be maintained solely for one or more core purposes and for one or more prescribed ancillary purposes. See s 62 of the SIS Act. 2 See for example the discussion in Commonwealth of Australia, Super System Review Final Report Part 2, June 2010, 202 (Cooper Review); Rice Warner Actuaries Pty Ltd, Investing in the Retirement Years (July 2011) 1. 3 Mercer, Securing Retirement Incomes: The Australian Retirement Income Challenge (November 2010) 1. 4 David Knox, Addressing The Market Failures In Post Retirement Products Actuarial Issues (2011) Law Council of Australia Legal Practice Section, 1. 5 Rice Warner Actuaries Pty Ltd, above n 1, 7. 6 Towers Watson, Finding The Balance: Strategies To Improve Post Retirement Investing (2012) 3; Commonwealth of Australia, above n 2, Towers Watson, above n 6. Towers Watson analysis supports bearing as much risk as possible throughout the retirement phase. A 90% growth strategy had the lowest probability of ruin (running out of money) beyond age 89.

2 Why is there concern that using a single default strategy for both pre and post-retirees may not be optimal for retirees? 2.4 Concern exists that using the same default strategy for retirees as for members in the accumulation phase is not optimal because retirees face a number of issues that either those still working do not, or that impact more heavily on retirees. These issues include: 8 (d) longevity risk the risk that a person outlives their retirement savings or must draw down lower pension payments and become frugal in their spending. This arises essentially because an individual has no way of knowing when they will die and so cannot plan their retirement income with certainty or budget a prudent amount to withdraw each year during retirement. As Rice Warner points out, 9 this is essentially a problem of adequacy; living a long time is only a problem if it cannot be done comfortably and with dignity. If individuals had more money accumulated, it would be a joy and a privilege to have abundant leisure time backed by financial freedom. However, Rice Warner reports that most Australians are not saving enough to provide them with a comfortable living in retirement. Their benefit will run out relatively early in the retirement years or they will need to draw lower annual benefits than expected; 10 inflation risk inflation can dilute fixed incomes in real terms. 11 Although inflation levels are currently low, many retirees have lived through periods of high inflation and may fear the return of high inflation; 12 capital losses from volatile investments even with a long time horizon, retirees are risk averse 13 and want peace of mind 14 Capital losses are more painful when income from personal labour no longer exists and this is especially concerning when markets are depressed, such as during the Global Financial Crisis. The risk is that assets must be realised at depressed values when liquidity is needed in retirement. 15 Research has shown that the income certainty is more important for retirees than tax breaks or exceptional returns 16 and this aspect is difficult to capture in most quantitative frameworks; 17 liquidity risk/uncertain expenses although retirees can predict regular expenses to some extent, individual health expenses are virtually impossible to predict. Further, expenditure patterns may vary during different periods of retirement, such as active, passive and frail periods. Individuals move through these phases at different rates, so it is difficult to budget with certainty; 18 (e) bequest motives many retirees have a strong desire to leave some money to their children or favourite charity; 19 (f) mental faculties while some retirees enjoy managing their money shortly after retirement, this can become impractical or impossible later in life; 20 and 8 See for example, Rice Warner Actuaries Pty Ltd, above n 1, 2; Knox, above n 4, 3; Towers Watson, above n 6, 4. 9 Rice Warner Actuaries Pty Ltd, Surviving Longevity (March 2010) Ibid Rice Warner Actuaries Pty Ltd, Investing in the Retirement Years, above n 1, Knox, above n 4, PIMCO Australia Pty Ltd, Behavioural Finance and the Post-Retirement Crisis (May 2011) Towers Watson, above n 6, Rice Warner Actuaries Pty Ltd, Surviving Longevity, above n 9, PIMCO Australia Pty Ltd, above n Towers Watson, above n 6, Rice Warner Actuaries Pty Ltd, Investing in the Retirement Years, above n 1, Rice Warner Actuaries Pty Ltd, Surviving Longevity, above n 9, 4; PIMCO Australia Pty Ltd, above n 13

3 (g) legislative risk superannuation, taxation and pension rules are constantly changing and this can scare retirees. 2.5 In a nutshell, most retirees wish to be protected from risks to their capital (such as longevity, inflation and investment), achieve good returns on their retirement benefit and have access to their capital to meet unexpected expenses or to leave some money as a bequest. 2.6 Of course, individual retirees will look at each risk differently. For those with retirement balances under $250,000, investing to counteract longevity risk is nonsensical because they have insufficient assets to fund themselves to their life expectancy, let alone an advanced age. They will be more focused on liquidity risk. More complex considerations are required for those with balances above $250,000. Once a member's balance reaches over $750,000 they should be able to live off the earnings on their account and only draw down capital later in life. 21 Further, it has been found that individuals with more labour supply flexibility are more likely to invest a larger proportion of their portfolio in risky assets, regardless of their age Accordingly, the use of a default option for retirement products that is identical to that in the accumulation phase may insufficiently cater for the particular issues facing retirees, and also implicitly combine the highly individual investment needs and aspirations of retirees into an "average" strategy However, industry continues to grapple with the "ideal" post retirement investment strategy. 24 Strategies that manage both liquidity and longevity risk remain elusive 25 and it may not be possible to address liquidity and longevity needs via a single composite investment option. 26 An "ideal" solution probably does not exist, but trustees will need to consider whether there is something better than what they are currently doing. 27 Why is it so important to look at default options set by trustees? 2.9 It is particularly important to look at default options in the post-retirement space for a number of reasons: 28 difficulties in engaging and educating members about superannuation, together with decision-making inertia, have led to default investment options being overwhelmingly the most common investment strategy used by investors; 29 members often see default options as an "endorsement" by the trustee. 30 This issue arises particularly with respect to older retirees when the quality of their decision-making decreases. Research has shown that: Agarwal. S., Driscoll, J, Gabaix, X., and Laibson, D. (2009) The Age of Reason: Financial Decisions Over The Life-Cycle and Implications for Regulation (Brookings Papers on Economic Activity) 2, cited in Allianz, Behavioural Finance and the Post-Retirement Crisis A Response to the Department of the Treasury/ Department of Labor Request For Information Regarding Lifetime Income Options For Participants and Beneficiaries in Retirement Plans (29 April 2010) Rice Warner Actuaries Pty Ltd, Investing in the Retirement Years, above n 1, PIMCO Australia Pty Ltd, above n 13, Rice Warner Actuaries Pty Ltd, Investing in the Retirement Years, above n 1, Towers Watson, above n 6, Ibid. 26 Rice Warner Actuaries Pty Ltd, Investing in the Retirement Years, above n 1, Towers Watson, above n 6, See also National Bureau of Economic Research, The Importance Of Default Options For Retirement Savings Outcomes: Evidence From The United States (January 2006). 29 Mercer, Default Investment Options Strategies Puts Australians Retirement Funding at Risk (21 April 2010)

4 (i) after age 53, the quality of financial decision-making deteriorates; (ii) after age 60, the prevalence of dementia approximately doubles every five years; (iii) more than half of those in their 80 s will suffer from dementia or significant cognitive deficits; and (iv) older adults show marked decline in numeracy, i.e. the mathematical skills needed to deal with everyday life and information, and in understanding simple measures of risk; and trustees are seen as best-placed to ensure optimal retirement outcomes because they understand the risk profile of the overall fund membership (and of specific sub-groups of the membership) and therefore can identify an appropriate level of risk for the "average" default member, and hence design an appropriate default strategy that aims to deal with risk at increasing ages. 32 The Cooper Review considered that the best way to promote the interests of super fund members in retirement was to ensure trustee accountability. It considered that trustees are best placed to understand the particular demographics of their funds' membership bases, to communicate with those members about the risks and options involved, and to mobilise service providers to deliver the most appropriate retirement products Accordingly, default option design is extremely important. Defaults need to encourage retirees toward optimal retirement income decisions and superannuation fund trustees are seen as being "on the hook" for default design that leads to suboptimal retirement outcomes Before we investigate this issue further from a trustee perspective, however, it is useful to pause at this point and remind ourselves of the current duties the SIS Act imposes on trustees in relation to investment strategy and the new duties that will soon be imposed on trustees through the Superannuation Legislation Amendment (Trustee Obligations and Prudential Standards) Bill 2012 (currently awaiting Royal Assent) (TOPS Bill). 3. TRUSTEE DUTIES SPECIFICALLY IN RELATION TO INVESTMENT STRATEGY Section 52(2)(f) covenants 3.1 Currently, s 52(2)(f) of the SIS Act effectively 34 requires superannuation trustees to formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the fund. Circumstances that must be considered include (without limitation): the risk involved in making, holding and realising, and the likely return from, the fund's investments having regard to its objectives and its expected cash flow requirements; the composition of the fund's investments as a whole, including the extent to which the investments are diverse or involve the entity in being exposed to risks from inadequate diversification; 30 National Bureau of Economic Research, above n 28, Agarwal. S., Driscoll, J, Gabaix, X., and Laibson, D., above n Towers Watson, above n 6, Commonwealth of Australia, above n 2, By deeming the governing rules of a superannuation entity to include a covenant by the trustee of the entity to this effect.

5 the liquidity of the fund's investments having regard to its expected cash flow requirements; and (d) the fund's ability to discharge its existing and prospective liabilities. Additional duties under the TOPS Bill 3.2 The TOPS Bill elaborates on trustees' duties in relation to investment strategies. In particular, trustees must: have regard to valuation information, expected tax consequences and costs in formulating, reviewing regularly and giving effect to an investment strategy for the whole of the fund, and for each investment option (our emphasis); 35 exercise due diligence in developing, offering and reviewing regularly each investment option; 36 and ensure the investment options offered allow adequate diversification. 37 As under the current law, these specified items are not exhaustive. Trustees must formulate, review regularly and give effect to investment strategies taking into account all relevant considerations, not just those specified. 3.3 In addition, the TOPS Bill seeks to implement an extremely important change for directors of corporate trustees (Trustee Directors). 3.4 Currently, to access the defence to an action for loss or damage in relation to an investment (provided by s 55(5) of the SIS Act), a trustee must show that the investment was made in accordance with the investment strategy formulated under the s 52(2)(f) covenant as set out in paragraph 3.1 above. 3.5 When the TOPS Bill becomes law, s 55(5) will be amended so that a trustee must comply with all relevant covenants and MySuper obligations in order to be able to access the defence to an action for loss or damage in relation to the making of an investment. Therefore, a trustee's investment decision could be challenged on the basis that it was not in the best interests of beneficiaries and the trustee will not have a defence for investment loss unless it can establish that it complied with all of the covenants and MySuper obligation. Duties with respect to MySuper Products 3.6 In relation to a MySuper product only, trustees (MySuper Trustees) must also: promote the financial interests of MySuper beneficiaries, and in particular returns to those beneficiaries (after the deduction of fees, costs and taxes); determine annually that there is sufficient scale in the MySuper product (in terms of assets and beneficiaries) so as to not disadvantage the financial interests of beneficiaries relative to the financial interests of beneficiaries in other MySuper products; include in the investment strategy the details of the trustee's determination of scale as described above; and 35 Superannuation Legislation Amendment (Trustee Obligations and Prudential Standards) Bill 2012 (Cth) (currently awaiting Royal Assent), s 52(6). 36 Ibid s 52(6). 37 Ibid s 52(6).

6 (d) include in their investment strategy an investment return target (over a rolling 10 year period) for the MySuper assets and level of risk appropriate to those assets. 3.7 In relation to 3.6 and 3.6(d) respectively: The duty in 3.6 raises an interesting dilemma for trustees with older members. Would the law require trustees to seek to promote returns for beneficiaries, at the expense of managing risk appropriately? The Explanatory Memorandum for the TOPS Bill (EM) states that the obligation to promote the financial interests of beneficiaries necessarily includes consideration of the level of investment risk appropriate for these members, recognising that different groups of members may have a different risk tolerance and there is a trade-off between return and investment risk. This is a sensible approach and would be required by what we consider to be the primary obligation of this proposed legislative clause, being the promotion of financial interests of beneficiaries, rather than simply maximising returns. With respect to 3.6(d), the EM states that in determining the risk appetite for the investment of its MySuper assets, a trustee may consider members' age. 38 In addition the EM states that a trustee's obligation to consider the investment return target and level of risk for a MySuper product must be done in parallel, reflecting the inherent trade-off between a target investment return and related investment risk Considering the additional duties relating to MySuper products is currently beyond the scope of post-retirement issues, because MySuper products are not required to include a post-retirement income stream. However, it is expected that the Government will give consideration in the future to such an inclusion 40 and, in our view, it is a prudent trustee that ensures they will be in a position to meet their duties in relation to post-retirement products when this requirement arises. Other duties that impact on investment strategy 3.9 It is also important to remember that the SIS Act and the general law impose 41 general duties on trustees that may impact on decision-making in relation to investment strategy. Trustees must: exercise, in all matters affecting the superannuation fund, the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide; 42 and ensure their duties and powers are exercised in the best interests of the beneficiaries The TOPS Bill alters the duty described in 3.9 above, so that trustees will be required to exercise the same degree of care, skill and diligence as a prudent superannuation trustee would exercise. This is a higher standard than the current ordinary prudent person test Explanatory Memorandum, Superannuation Legislation Amendment (Trustee Obligations and Prudential Standards) Bill 2012 (Cth) (currently awaiting Royal Assent) Ibid. 40 Wouter Klijn, Costello Flags Possibility Of My Pension (23 June 2011) Investor Daily 41 Again, SIS effectively imposes these duties by deeming the governing rules of a superannuation entity to include a covenant by the trustee of the entity to this effect. 42 Superannuation Industry (Supervision) Act 1993 (Cth) s 52(2). 43 Ibid s 52(2). 44 We note that State and Territory trustee legislation currently imposes a professional trustee standard in relation to investments.

7 New duties on trustee directors 3.11 Importantly, the TOPS Bill also seeks to apply 45 new duties to the directors of corporate trustees of registrable superannuation entities Currently, a director of a corporate trustee is required to exercise a reasonable degree of care and diligence (to the standard of a reasonable person) for the purpose of ensuring that the corporate trustee carries out its covenants. However personal duties (e.g. to act in the best interests of beneficiaries) do not apply to the directors of corporate trustees in their own right The TOPS Bill imposes additional duties on each director of a registrable superannuation entity, which reflect the duties imposed on the corporate trustee itself, including: to exercise the same degree of care, skill and diligence as a prudent superannuation entity director would exercise in relation to an entity where he or she is a director of the trustee of the entity and that trustee makes investments on behalf of the entity's beneficiaries; to perform the director's duties and exercise the director's powers as director of the corporate trustee in the best interests of the beneficiaries; and to exercise a reasonable degree of care and diligence to ensure that the corporate trustee carries out its duties under s 52 of the SIS Act Further, each director of a MySuper Trustee must exercise a reasonable degree of care and diligence to ensure the corporate trustee carries out the additional duties imposed on MySuper Trustees as outlined in paragraph 3.6 above. 46 The degree of care and diligence required is that a superannuation entity director would exercise in the corporate trustee's circumstances. 47 A superannuation entity director is a person whose profession, business or employment is, or includes, acting as a director of a corporate trustee of a superannuation entity and investing money on behalf of beneficiaries of the superannuation entity The overall effect of these changes is to hold directors of corporate trustees to a higher standard than currently A person who suffers loss or damage because a director contravened these obligations may recover the amount of the loss or damage by an action against the director, or any other person involved in the contravention, commenced within six years after the day the cause of action arose. 49 Importantly, the defence under s 55(5) (as amended and as discussed in paragraphs 3.4 and 3.5 above), applies to such an action for loss or damage We note that State and Territory trustee legislation currently imposes a professional trustee standard in relation to investments. 45 Again, SIS effectively imposes these duties by deeming the governing rules of a superannuation entity to include a covenant by the trustee of the entity to this effect. 46 Superannuation Legislation Amendment (Trustee Obligations and Prudential Standards) Bill 2012 (Cth) (currently awaiting Royal Assent) s 29VO(1). 47 Ibid s 29VO(2). 48 Ibid s 29VO(3). 49 Ibid s 29VP. 50 Ibid s 55(7).

8 Comments in recent reviews 3.17 In the Cooper Review, 51 the panel (Cooper Panel) noted that, while the factors outlined in current s 52(2)(f) of the SIS Act can cover post-retirement concerns, the risk profile, tax treatment and liquidity needs of retirees are likely to be different from those of members in the accumulation phase. It considered that the use of a single investment strategy for a superannuation fund might not be appropriate once post-retirement assets become substantial. 52 The Cooper Panel thought it important to ensure that MySuper Trustees are responsible for devising an investment strategy not just for the fund as a whole, but for the assets held on behalf of post-retirement members. Trustees would work out how to fulfil these new specific duties in the circumstances of their fund's particular characteristics The Government supported the recommendations of the Cooper Panel requiring a separate investment strategy for both post-retirement members in MySuper products and other choice products that offered income streams. 54 Unfortunately, the TOPS Bill did not deal with this issue, but it is hoped that, in time, the Federal Government legislates in accordance with its response to the Cooper Review The Henry Review 56 stated that having a wider choice of retirement income stream products would be beneficial to retirees, and that product innovation should be encouraged. It was also recommended that the Government remove the prescriptive rules relating to income streams in the Superannuation Industry (Supervision) Regulations 1994 (Cth). 57 Complying with legislative requirements 3.20 Even though there is not yet a mandated requirement to have a separate investment strategy for post-retirement members, the question arises as to whether a trustee could still fail to meet its current duties under SIS if it does not give consideration to such an option It is possible that a retired member (or, importantly, a group of retired members in a class action) could argue that the failure to have a separate investment strategy for retirees constitutes a failure to give effect to an investment strategy that has regard to the whole of the circumstances of the fund. 58 This could be difficult to establish, given that trustees could invoke reasons why an identical strategy for post-retirees as for accumulation members could be appropriate. See for example the reasons outlined in paragraph However, there is a possibility that such an argument could be successful, given the reasons identified above as to why retirees face different issues to accumulation members (recognised by the Cooper Review and supported by Government). If the argument were successful, we believe the trustee would not have available to it the defence under s 55(5) of the SIS Act on the grounds that one of relevant circumstances of the fund was not considered Importantly, however, even where the trustee could establish that it had met its duties under s 52(2)(f) of the SIS Act, a member, or group of members, could argue that the trustee had failed to meet its duty to: 51 Commonwealth of Australia, above n Commonwealth of Australia, above n 2, Ibid. 54 Commonwealth of Australia, Stronger Super, 2010, Ibid. 56 Commonwealth of Australia, Australia s Future Tax System: Report to the Treasurer, December 2009 (Henry Review). 57 Ibid Superannuation Industry (Supervision) Act 1993 (Cth) s 52(2) s 52(2)(f).

9 exercise the required degree of care, skill and diligence; exercise its powers in the best interests of beneficiaries; and treat different classes of members fairly (which is a general law duty) Under current law, this would not impact a superannuation trustee, given the defence available to it under s 55(5) of the SIS Act. However, when the TOPS Bill becomes law, trustees will be required to comply with all relevant covenants and MySuper duties in order to be able to access the defence to an action for loss or damage in relation to the making of an investment. Therefore, if a trustee fails to meet just one of the various duties outlined in paragraphs 3.23, 3.23 and 3.23 above, the defence under s 55(5) falls away Also importantly, individual trustee directors will be subject to new duties (as set out in paragraphs 3.11 to 3.16 above), and would be directly and personally liable to fund members that have suffered investment loss where they have breached those duties. Way forward 3.26 It is imperative that the Australian regulatory system supports the creation of innovative retirement financial products. While there may never be an ideal, or one-size-fits-all, product that will meet every retiree s needs, it is important that regulatory settings allow something better than the current offering to be created. Finally, trustee directors must be on their toes in relation to the entire post-retirement space to ensure compliance with both current and future trustee and trustee director duties. For further information please contact: Jane Paskin Partner T jpaskin@claytonutz.com AUGUST Sydney T Melbourne T Brisbane T Perth T Canberra T Darwin T Hong Kong T Persons listed may not be admitted in all states and territories. This document is intended to provide general information. The contents do not constitute legal advice and should not be relied upon as such. Clayton Utz 2012