The pig in a python drives a rethink on retirement income

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1 The pig in a python drives a rethink on retirement income A looming demographic shift will challenge financial planners ability to produce income solutions for clients. But fund managers are under increasing pressure to find smart solutions, too. Simon Hoyle reports. It has been estimated that by the year 2025, there will be more money being withdrawn from superannuation than being contributed to it. This fundamental shift will be the result of the pig in a python demographic of the Baby Boomers as they switch from the accumulation phase of their superannuation lifecycle to the drawdown or decumulation phase. That s quite a big change, considering that the Australian Prudential Regulation Authority (APRA) says that in the year to June 30, 2010, there was $70 billion added to the system by way of contributions, and $35 billion by way of investment earnings. Since the advent of the Superannuation Guarantee (SG) regime in 1992, the focus of fund members, fund managers and advisers has been on the accumulation of funds, and issues associated with that activity (including contribution levels, choice of fund and choice of investment strategy, and investment performance). The aim, obviously, has been to maximise members savings, within relevant risk parameters, so they enter retirement with the greatest possible sum of money on which to generate a regular income. By and large, the system has done this well. What it has done less well is meet the retirement income needs of members. As things stand, the general approach by super funds to providing retirement income solutions is to create some sort of account-based product, which is designed to produce regular income, but which is often based on the same asset allocation that the member had during the accumulation phase. But that focus must shift, and the skills needed to construct robust portfolios that can meet the income needs of an individual over their expected lifetime in retirement are quite different from the skills needed to build accumulation portfolios. A white paper entitled Super Fund Retirement Planning how prepared is your fund?, written by Tony Hildyard, a senior vice president for fund manager Pimco, says the post-retirement income product market is underdeveloped. The recent Super System Review has recognised that the retirement income market is underdeveloped, currently dominated by account-based products with little product innovation to manage longevity risk for retirees, the white paper says. The combination of the changing demographics of the Australian population, [and] the limited product offerings is driving the industry to focus on retirement products and on retiree needs. It s not only the case that the asset allocation and structure of a product designed to deliver an individual s income needs should be different from the allocation and structure during the accumulation phase. Hildyard says it s also clear that an individual s attitudes towards investing change quite markedly as they first get close to, and then move into, retirement. He says they become more risk-averse; they become less tolerant of volatility; they want greater control of their assets; and the issue of longevity becomes very real to them. Dealing with their income needs, therefore, is as much about dealing with behavioural issues as it is about dealing with technical asset allocation issues. And those behavioural issues must be addressed, Hildyard says. It s a problem that we ve been aware of for quite a while, but it s going to get bigger rather than smaller, he says. The current trend is, in general, that if your balance is quite small, you spend it and you get the Government pension; or you leave it in the fund and you get an account-based pension, which is based on the same asset allocation as the fund was running when you retired. If you have a larger balance, you take a lump sum, set up a self-managed super fund or get some private advice and get into a retail retirement fund that suits your needs. Hildyard says there s nothing necessarily wrong with the latter approach except that retail

2 funds can be relatively expensive. But staying in a fund to receive a pension might not be the better option, because the asset allocation of the fund might not be optimal for supporting an income stream that may have to last 20 years or longer. The argument to support the account-based approach is that in the long run, the asset allocation will, on average, produce a return sufficient to see you out. But on average means that 50 per cent of the time you ll be OK, Hildyard says. And when you plan your retirement, you do not plan on there being only a 50 per cent chance of there being enough money. The longevity issue is addressed by structured products such as OnePath s MoneyForLife product, and AXA s North product (both offer capital protection, and the opportunity for income to rise over time), and by a product that for some time fell from favour: the annuity. Phil Anderson, senior business development manager for Challenger, says the allocated pension is now 20 years old as a product. It was the best retirement income solution at the time, but it s time for better product solutions. If you do historical back-testing, [an allocated pension strategy] has delivered a huge variation in return, or the longevity of capital, over that period, Anderson says. Really, with the same strategy, starting every year, you could have had a whole different range of outcomes, whether it was starting in 1994, when bond markets went up and down. It really highlights that the first one or two years is vitally important in the first part of your journey. Getting the boat off the wharf is the really important part, without getting smashed on the rocks in the first couple of years. If you lose 20 per cent [of your capital] in the first year, and you draw down 5 [per cent], you re down to 75c [in the dollar]; you ve got to do 33 per cent to get back to square. Then you draw 5 per cent and you ve got 95c and you re still not back at square. And so it goes on. Also, if you look at the last cycle, where people had two or three years cash put aside for income, and then the cash account started to dry up, the dividends were reduced and people looked to their mortgage funds and those mortgage funds suddenly froze, people had to turn to their growth assets at the wrong point in the cycle. [So we go] back to the drawing board again and say we re not happy with this 20-year history. It hasn t been the proudest of pasts. It s been OK for some people, but the same strategy launched every month through every year of the 20 years has got wildly different results. Anderson says that instead of looking at patching the best group of assets together to get the job done, we should look at it from the liability side. What is it that I m trying to achieve here? he says. It goes back to Grandma with her seven jars on the mantelpiece, with money for housekeeping in one, [money for] clothes in the next and for transport in the next one, and so on. So what are we trying to achieve here? Mark those off and lock them away individually. If you can do that without taking on additional risk, even better. Let s actually focus on what we re actually trying to achieve, whether it is three years worth of school fees, it is 10 years of age care fees or it is 30 years of retirement income, but focus on trying to achieve the income goal, not just trying to get outperformance chasing alpha. My belief is that it s all about cashflow, managing cashflow - that will get you far better results than chasing alpha. Anderson says that after a planner has completed an 18-page fact find, an investor s goals and income requirements - and how to achieve them - should be crystal clear What are your goals? Well, I want an emergency cash reserve; I want some bedrock income; I want some discretionary income, or they call it aspirational income, a holiday account, beyond the bread-and-milk stuff - and we ve seen people layering their income like this, he says. If you like that style of indexed income-forlife that the Government gives you, you can also buy it from us [in the form of an annuity]; and then on top of that you can have your allocated pension with a bit of growth and a more aggressive diversified income approach. The purpose of super, really at the lower end, is to provide lifetime income; it s not really about estate planning at all. You ve got $300,000, and it s got to last you 35 years; forget an inheritance - you re not in a position for that. If you ve got $2 million, it s a different story. So let s commit this money to doing its

3 job, rather than dancing around in circles and giving money to the kids and that kind of stuff. This is money that s got to last you for the period. And the problem we have with the 89-year-olds, they don t spend anything, because they grew up during the Depression and the war, and they re very thrifty; but the Baby Boomers coming through are all very good spenders. And we re living five or six or seven years longer, and we re spending money three times faster - it s just a train smash waiting to happen. Anderson says the key to meeting an individual s income needs is matching the assets to the liabilities. We ve got a person here who we re paying for the next five years, and another person over here who we re paying for the next 35 years - what are we buying to back those [liabilities]? he says. In some respects, the income products promoted by Challenger in particular are quite old-fashioned. A lot of the older guys are saying, yep, we did this 20 years ago, what a great idea, I d forgotten about this residual capital value (RCV) zero-type strategy, where you put half your money in that and you put half your money in growth, Anderson says. They re saying, We did that back in the 80s and 90s, and gee it worked well. And I m saying, Well, what changed? I think the advent of the wrap probably pushed them that way, where they all decided to manage the sector funds themselves. So to get them back now and say, we ve not made a mistake, but we need to have a hard look and say, well, did we stray from the path? But I think it s a matter of layering all these different strategies together: have your guaranteed strategy; have your diversified asset strategy on top of that, but up the pyramid. It s a matter of layering different types of strategies to achieve your goals, because the future will do what the future will do, and no one approach is always going to have the best outcome. Kathy Cave, a portfolio manager for Russell and the manager of the Russell Australian Enhanced Income Equity Fund, says the approach to managing an income product is different from managing a product for someone still in accumulation mode. Some managers use core-plus strategies, which may include an investment offshore, which is typically hedged, as well, Cave says. If the currency changes, you may need to put some money towards your hedging costs and that may gobble up some of your income. The fund we have designed for income doesn t have those kinds of strategies. Ben Moore, a regional manager with Russell, says there is clearly rising interest among financial planners for better and more flexible income product solutions. Definitely we are seeing an The purpose of super, really at the lower end, is to provide lifetime income increase in requests from advisers for conservative and conservativelike funds, as well as those with an income [focus], Moore says. I look at the ABS data, and we re seeing more and more people looking to retire every year and for the next 15 years. Moore says there s a greater level of specialisation by planners, too, and among those who are focusing on the pre- and postretirement market there s a growing clamour for better ways to address their clients income needs. If Hildyard s assessment of the behavioural characteristics of retirees is correct, then managers face the daunting challenge of producing products that generate attractive levels of income, with limited volatility and downside risk, and the prospect of some capital gain. Angus Crennan, an investment specialist with Zurich Investments, says it s possible to achieve all those objectives in one fund. And what s more, the asset allocation and investment strategy of such a fund does not necessarily need to change when an investor moves from accumulation phase to decumulation phase. In October this year the Zurich Equity Income Fund will turn five years old. Crennan says that over that period the fund has met its objective of delivering a 10 per cent running yield. At the same time it has provided some downside protection, and delivered a conservative level of growth. It achieves this performance by investing in high-yielding blue chip Australian shares and using intelligent options strategies to both generate additional income for the fund (in addition to dividend income and associated franking credits) and protect its capital. The tradeoff is that a reduction in overall volatility means a reduction in upside volatility, too; the price an investor pays, as it were, for receiving an attractive and reliable income stream is that they will not

4 always benefit fully from a strongly rising market. The effect of the options strategy, says Crennan, is to effectively take the volatility associated with equities and swap it for income. In ideal circumstances, the fund buys equities and sells covered call options; depending on the strategy chosen, the income it receives can then more than cover the cost of protective put options, which place a floor under the capital value of the share component of its portfolio. The portfolio must be actively managed - it is managed for Zurich by boutique funds management firm Denning Pryce - because it s not as simple as just buying a share and then selling a call option and buying a put option every single time. Crennan says the characteristics of the fund address some of the shortcomings in earlier incomeproducing strategies. Bonds get you some capital gains, but you also have the risk of capital loss, Crennan says. The global financial crisis (GFC) has reminded us that credit can exhibit equity-like characteristics. I ve seen some strategies for investors that are going to return the final coupon and your principal in a known period of time. So short of default risk, an investor will intend to consume the principal and the income to live off. As the investor now has known cashflows coming up, they can allocate a part of their capital to growth assets; because they now have time before they need to consume their growth assets, the volatility doesn t worry them as much. I am not talking about a structure where you use a fund manager to blend asset classes. That s very feasible; you could use an asset manager that s going to take long/ short positions, or could invest in bonds or in other strategies. What I m specifically talking about is a cashflow strategy based around the cashflow certainty of bonds, assuming there is no default by the bond issuer. You are investing in the bond with the deliberate strategy to hold it to maturity to receive back the coupons along the way, and then you intend to consume that principal. In Australia we have a wholesale bond market and retailifying it is quite a difficult challenge. Even if you could invest like an institutional investor, and you were able to take six or eight bonds to put together a portfolio that was going to [provide] you cashflows for the first X period of your retirement, and then you were comfortable to invest the residual part of your portfolio into growth assets such as the equity market, you ve still got no capital growth from the bond part of your portfolio, because you re holding the bonds to maturity. A reasonably recent development was, I don t know if you can call them the first generation of equity income funds, but what they targeted was high-yield shares. So these are cash cows, if you like - very, very good businesses that are either significant players or dominant in their markets, have healthy Bonds get you some capital gains, but you also have the risk of capital loss margins, and you re not focusing so much on their earnings per share growth, you re buying them because their operating cash flows are attractive and their dividend yields are high and sustainable. You re taking that income plus the franking, and you re happy to give away some of that earnings growth during periods of rapid economic expansion, and instead you re taking on a potentially slower level of growth but more certainty around the sustainability of income, and by virtue of the fact that they re bigger, more robust and diversified businesses you ve probably got a lower level of volatility. What you ve still got with that portfolio is a market risk. You have a mandated manager that has to go long, that has a level of cash that they re able to go to. It might be 10 per cent, it might be 20 per cent, but apart from that they have to be fully invested in the equities market, which means you ve got market risk. And the other side of that is that your income is the payout ratio that the board of directors decides on. You don t really have that much control over what you receive. What we saw in the GFC was a lot of companies, their operating cashflows declined, and so we saw pretty severe dividend cuts. Being able to utilise an options strategy that can not only manage volatility, but also generate additional income in all market conditions, is a desirable capability in that environment.

5 Order the investment with the lot TM Zurich HelpPoint Give your clients share exposure that s made-to-order. The Zurich Investments Equity Income Fund aims to provide 10% income per annum*, with lower volatility than the overall sharemarket and offers long-term capital growth. It s skilfully prepared by a renowned team using the finest, blue-chip Australian shares and conservative exchange traded option strategies. With no nasty by-products, such as financial leverage, it s a dish you can confidently serve up to your clients. For more information call or visit 10% income* p.a. + downside protection + capital growth *Based on a running yield. Consider the Zurich Investments Equity Income Fund PDS. Past performance is not a reliable indicator of future performance. Zurich Investment Management Limited ABN , AFSL , 5 Blue Street North Sydney NSW DAMO ZU20641 V1 07/11 / ZI0007