In a little over six months, all superannuation trustees will have a legal obligation to consider the retirement needs of their members. It sounds self-evident, but it isn’t the way super funds have been set up.
Superannuation trustees today must look after the best interests of members, but most of the focus has been on the accumulation stage of growing wealth, rather than the decumulation stage.
With money in decumulation phase now heading towards $1 billion, from a total superannuation pool of around $3.3 billion1, the government has pushed super trustees to spend more time thinking about how retirees should spend their money.
The federal government has now prepared draft legislation that will force trustees to consider a strategy for individual members once they retire.
At the moment, many retirees simply roll over into account-based pensions which may not provide the best outcomes for retirees. This is because an account-based pension was developed with one primary objective – to push all risk onto the retiree instead of the employer/fund/sponsor. Retirees are exposed to a myriad of risks including sequencing, longevity, inflation and behavioural risk, as well as issues such as cognitive decline and elder abuse. It is little wonder then that the majority of retirees draw the minimum from their account-based pensions and as a consequence do not enjoy the comfort and confidence that could otherwise afford.
The Retirement Income Covenant, slated to commence on 1 July 2022, is a game changer for superannuation funds.
Before we go into that, first, a quick lesson in Australian superannuation history.
The Age Pension was introduced in Australia in 1909 and its coverage, settings and means test for eligibility have been changed many times.
Prior to the 1986 National Wage Case, superannuation was generally limited to public servants and white-collar employees of large corporations. Following the 1986 National Wage Case, provisions for superannuation were included in some awards, and then in 1992, the Superannuation Guarantee (SG) was introduced.
It began at three per cent of ordinary time earnings on 1 July 1992 and has gradually increased to today’s rate of 10 per cent. It is legislated to reach 12 per cent on 1 July 2025. Voluntary contributions to superannuation are also encouraged through tax concessions2.
The SG has solved some of the challenges of an ageing workforce, but certainly not all. As of June 2019, around 71 per cent of people aged 65 and over received the age pension or other pension payments. Over 60 per cent of these were on the maximum rate.
But at least after almost 30 years, the SG has allowed people to better save for their retirement. And enough money is now in the decumulation stage that more focus needs to be put on how it is spent.
This involves many issues, from adequacy and equity of retirement incomes, through to sustainability and cohesion. That is what the Retirement Income Covenant is expected to address.
The Retirement Income Covenant
The Retirement Income Covenant will ensure superannuation trustees have a legal obligation to consider the retirement income needs of their members. Those that do not may be liable for civil penalties.
It’s great news for superannuation members, and particularly given that traditional income assets such as fixed income are offering such paltry returns, it’s not a moment too soon.
The Retirement Income Covenant should deliver more choice and better products for retirees. Today many retirees have their funds invested in the same way as accumulation members, despite significant differences in needs and objectives.
In these pooled options the tax advantages of being a retiree are lost and savings are not fully being used to fund a retirement income.
The Retirement Income Covenant is a great opportunity for superannuation funds to differentiate themselves by providing tailored and tax-effective solutions to an engaged and rapidly growing segment of the market.
What will a super fund have to do?
From 1 July 2022 superannuation trustees will have a legal obligation to develop and publish a strategy to assist members achieve the following objectives:
- Maximise their expected retirement income.
- Manage expected risks to the sustainability and stability of their expected retirement income.
- Have flexible access to expected funds during retirement.
Importantly the government has defined retirement income as after-tax income that includes age pension payments as well as superannuation drawdowns.
The age pension provides a substantial safety net in retirement, providing longevity and drawdown protection. For part-pensioners the asset test means that as asset values decrease the age pension will increase. This functions as an automatic stabiliser for retirement income in times of market weakness.
Including the age pension in the Retirement Income Covenant is a big deal as it allows trustees to focus on investing in growth assets which provide both a higher yield and better growth. Growth assets provide a more sustainable (reliable, durable and lasting) retirement income while the age pension can be used to manage the risks around stability, providing both a floor and an automatic stabiliser to retirement income. This is particularly important when inflation is above the yield of most fixed income assets.
What can superannuation trustees do to meet their obligations?
A retirement strategy does not need to be complex. The nature of the default system means any strategy needs to be understood by a member who may be disengaged with little financial literacy. Too many retirement solutions require a PhD to understand. By following a couple of simple principles’ trustees can drastically improve outcomes for their retired members:
- Better products. The government is encouraging trustees to develop a greater range of products that can complement (not replace) account-based pensions. Such products could provide more income throughout retirement by pooling longevity risk and sharing mortality credits, providing greater confidence that retirees won’t outlive their savings.
- Get to know your members. Everyone’s income needs are different in retirement. While some members will seek advice, many will not. Finding low hanging fruit to assist these members is important. The lowest hanging fruit is their age pension status. Members receiving a part-pension due to the assets test often benefit from an accelerated draw-down strategy as the taper rate means for every $10,000 of assets they draw-down (to pay off-debt, buy a house, go on a holiday etc.) they receive $780 every year in additional pension payments4. This helps replace lost investment income as assets reduce and supports spending needs when they are the highest in early retirement.
- Growth assets are often less risky than defensive assets in retirement. A trustee’s consideration of investment risk under the Retirement Income Covenant is different to the accumulation phase. Specifically, risks should be considered in the context of their impact on retirement income. This flips the understanding of risk as many traditional defensive assets provide less income and have greater inflation risk and longevity risk than growth assets. For example, the yield on cash today is substantially below inflation which makes cash a risky investment in a retirement income context. Even government bonds, one of the “safest” assets are often known to fall in value as inflation and interest rates rise, which seems inevitable from the current 0.1 per cent cash rate5.
- Cash flow matters. The lowest risk way to deliver retirement income is to match it to durable and growing underlying cash flow from investments. Relying on realised capital gains to support a member’s retirement income needs is a risky option that can force trustees to sell assets in weak markets. Income, such as dividends, is less volatile than capital gains and should form the backbone of any retirement income strategy.
- Franked dividends are the most tax effective form of investment returns. Retired members pay 0 per cent tax on their investment earnings. This means for every $1.00 in fully franked dividends they receive 43c in franking credits. Fully franked dividends are therefore worth 43 per cent more than a comparable capital gain6. Any retirement income strategy should seek to take advantage of this fact by focussing on fully franked dividends.
Retirement income strategies do not need to be complex, but they do demand a different approach to investing relative to the accumulation phase. Making a couple of simple changes to how savings are invested, combined with greater member engagement can greatly improve retirement income for members in a simple and easy to understand way.
Once the Retirement Income Covenant is voted into legislation retirees can look forward to some much-needed reform and better investment options in superannuation.
1. Australian Prudential Regulation Authority
2. Treasury.gov.au; Retirement Income Review Final Report (https://treasury.gov.au/sites/default/files/2021-02/p2020-100554-ud00b_key_obs.pdf)
3. Treasury.gov.au; Retirement Income Review Final Report (https://treasury.gov.au/sites/default/files/2021-02/p2020-100554-ud00b_key_obs.pdf)
4. ATO, AMP Capital
5. Reserve Bank of Australia (rba.gov.au)
6. ATO, AMP Capital
Subscribe to Institutional Edition using the form below to receive all of my articlesTom Young, Co-Portfolio Manager (Income)
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