Goals-Based Investing

Retirement income: A middle path between annuities & account-based pensions

By Jeff Rogers
Previous Chief Investment Officer, ipac (retired) Sydney, Australia

Investors have been bracing for a long-anticipated normalisation of interest rates and relief from a low-return world. But the harsh truth remains that yields on fixed income securities, which underpin many retirement income strategies, remain close to historical lows – the Australian government 10-year bond rate is just 2.8 per cent. Advisers and investors face an acute challenge finding sustainable sources of retirement income.

But goals-based funds are now providing a ‘third alternative” to the retirement income challenge. They’re seeking to overcome the limitations of existing approaches, and creating portfolios that blend some of the predictability of outcomes that annuities offer with the flexibility of account-based pensions invested through traditional funds.

By understanding the benefits of goals-based retirement solutions relative to existing options, investors and advisers will know they have another strategy at hand that is designed specifically to deliver outcomes aligned to retirement goals, even in this low-return environment.

The price of an annuity

An annuity has long been the ‘base line’ option for income in retirement but it comes with significant limitations.

To understand the pros and cons of various retirement strategies, let’s assume a couple has retired with $300,000 of assets. Their time horizon is 25 years and they have full entitlement to the age pension. Further let’s assume their spending rises with the cost of living over time.

If our retirees invest their $300,000 in a 25-year inflation-linked annuity, an insurer will pay them a series of inflation-linked cash flows over the subsequent 25 years. Investment risk has been transferred to the insurer and there is a clear line of sight of cash flow from day one. Our retirees know the extent of their purchasing power and exactly how long it will last.

But retirees typically don’t have full flexibility around access to their capital. And while investment risk has been transferred to the insurer, the retirees have counterparty risk - the risk the annuity provider can’t meet its obligations. Australian investors, however, can draw confidence from the fact annuity providers operate in a well-regulated market that require insurers maintain strong capital reserves.

But the biggest downside of annuities is the low implicit rate of return the retirees receive on their capital. As mentioned, prevailing nominal and inflation-adjusted interest rates are quite low, and insurers are required to hold additional capital if they take incremental investment risk. Investors in traditional annuities also don’t participate in any of the potential upside from share markets.

Traditional funds in an account-based pension

The second option for our retirees is to draw a regular income from their superannuation savings invested in a traditional fund within an account-based pension (also known as an allocated pension). In many cases it is the same fund in which they invested in accumulating their savings.
Account-based pensions have some significant benefits relative to annuities, including greater flexibility to access capital and the choice of strategies with a higher expected rate of return on capital.

But retirees face greater uncertainty with this option. All the investment risk remains with them. They face a wide range of possible outcomes, from spectacular to abysmal, depending upon their fund’s pattern of returns. The wide range of potential outcomes from a traditional fund in an account-based pension arises because of what is known as sequencing risk: the luck of the draw around the level of returns in the first few years of retirement when they have their greatest amount of capital.
That uncertainty means that, when markets deliver favourable outcomes, retirees with traditional funds in allocated pensions tend to be unnecessarily thrifty and don’t make full use of the potential spending power of their assets.

The problem is that the traditional fund simply hasn’t been tuned in any way to the retirees’ goal of 25 years of consistent spending power. Indeed, the fund manager has no idea retirees are using the fund to finance their retirement cash flows. Rather, the fund manager is focussed on the delivery of competitive long-term growth of capital.

Goals-based funds: a “third alternative”

The goals-based approach, operating within an account-based pension, seeks to find a ‘middle path’ between these two options: a higher cash flow than annuities; but a narrower and more predictable range of potential cash flow outcomes than from a traditional fund.

The goals-based approach explicitly acknowledges the retirees’ goal: to be confident of receiving reasonable, consistent inflation-linked cash flows for 25 years in a zero-tax environment. The fund manager truly understands the risks that the relevant cohort of retirees faces, including sequence risk and inflation risk.

The goals-based approach then asks: what specific things would I do to provide confidence around the delivery of the goal?

Ultimately, that suggests several things:

1. Ensuring cash flows are inflation-linked by emphasising investment in assets that perform in line with inflation, such as inflation-linked bonds and select real assets.

2. Incorporating downside protection into the portfolio, especially during the early phase of retirement because that’s the locus of greatest capital risk.

3. Taking advantage of the fact that retirees are investing in a ‘zero-tax’ environment. That, for example, means focussing on strategies to benefit from imputation credits in Australian shares.
Because these strategies are tuned to the cash flow goal, advisers are better placed to provide their client with regular advice on any adjustments that are required to the investment strategy or their rate of spending. This can instil greater confidence along the retirement journey and reduce the prospect that cash flows will run out unexpectedly or that the retiree underspends unintentionally.

A greater range of retirement strategies

One of the greatest challenges for retirement planning is that advisers and investors have a limited range of strategies to choose from.

An annuity can provide certainty; but that comes with relatively low levels of cash flow and weaker liquidity. The traditional fund in an account-based pension provides full liquidity and, on average, better cash flows, but carries significant ‘sequence’ risk leading to a wide variety of possible outcomes and an uncomfortable level of uncertainty.

A third option is needed. Goals-based investing is utilising the full skill set of multi-asset managers and applying this directly to the challenge of delivering reliable retirement income. The result are new goals-based options that provide advisers and investors with strategies that are giving retirees much greater confidence they can meet their retirement income goals.

  • Goals-Based Investing
  • Income
  • Retirement
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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.


This article is not intended for distribution or use in any jurisdiction where it would be contrary to applicable laws, regulations or directives and does not constitute a recommendation, offer, solicitation or invitation to invest.

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