Australian superannuation fund members have high levels of equity exposure by international standards and the collapse of share markets around the world during the global financial crisis (GFC) has smashed the value of retirement savings. This is an issue for all investors, but particularly for those in the so-called “critical zone” – from roughly five years before to five years after retirement. Any setback at this stage can have serious consequences for retirement income levels. Added to the issue of a sudden diminution in retirement savings is the fact that people generally are living longer than previous generations, and face the prospect of having to make capital stretch further. ING Australia says that for a couple aged 60 there is a 50 per cent chance that one will live to be 90 or older. If they retire at age 65, they potentially face at least 25 years in retirement. It’s the conventional wisdom that to generate income for that period of time, retirees need a relatively high exposure to growth assets. But the GFC has underlined one of the obvious potential pitfalls of such a strategy. “You need the engine room to be equities, in order to ensure that the money lasts well into retirement. At the same time, that engine room comes with risk, which is where [you need] that level of protection to ensure you’re locking in your portfolio along the way,” says Barry Wyatt, national manager of business development for AXA. As retirees grapple with investment and longevity risk, demographic factors mean the market for retirement income products continues to grow.
In 2007, roughly 14 per cent of the population was aged 65 or older. By 2047 the proportion will have increased to 25 per cent – of a larger population. Research by AXA has found that 83 per cent of retirees want stable income in retirement, and 72 per cent want protection from market downside. Almost half – 48 per cent – of advisers surveyed said they would recommend “to all or most of their clients” a product that offered these features. ING says 85 per cent of planners would recommend such a product. Clearly, conditions were right for a product solution that addressed retirees’ concerns but which avoided the disadvantages of previous generations of guaranteed income products. To retirement … and beyond The first step towards the new breed of guaranteed income products was arguably AXA’s North product, which offered guarantees on contributions and investment returns, a (limited) choice of investment strategies and access to capital at any time. The product was launched in November 2007 and fired the imaginations of investors and financial planners alike.
North has about $1 billion of funds under management, and continues to grow strongly. Now, AXA has extended the concept of the North product into the retirement income space. And others are following suit – first cab off the rank is ING Australia’s MoneyForLife product, which, while different in some detail to the North product, employs basically the same concepts to achieve the same results. This involves establishing a minimum guaranteed income level, based on the amount of capital invested at the beginning of a guarantee period. Fees for administration and so on are deducted in the normal way, and an additional fee is deducted to cover the cost of the guarantee. Although the guarantee is ultimately supported by the balance sheet of the company, the issuer uses the guarantee fee to offset the cost of its liability to the investor. Upon investment, the investor’s capital is guaranteed – a balanced referred to as a “protected income base”, or something similar. Over the course of the guarantee period, the fund pays a guaranteed minimum income to the investor.
At the beginning of the next guarantee period the guarantee is reset. The guarantee is set with reference to the higher of the previous guaranteed income base or the actual fund balance. Accordingly, if the fund value has increased, the guaranteed minimum income level is reset at a higher dollar figure; if the value of the fund is the same or has fallen, the guaranteed income level remains unchanged. The concept is simple, and readily understood by investors, who can see that their capital is protected, that they stand to benefit from rising markets, that they can rely on receiving a minimum level of income from the fund for the rest of their lives, and their guaranteed income can rise if the fund value rises. Such products remove two of the key risks facing retirees: investment risk and longevity risk. The value of the retiree’s capital cannot fall (other than by the amount of income drawn own, plus fees), and it does not matter how long they live – income is guaranteed.
The GFC in particular The chief executive of INGA, Harry Stout, says the development of guaranteed income products is an inevitable development in the Australian marketplace. “When I first came [to Australia from the US] I did notice that as we looked at the Australian financial landscape there weren’t really solutions aimed at lifetime retirement income,” Stout says. “The country’s done a great job one super…but if you look at superannuation it’s really geared towards accumulation, and hasn’t been geared to providing a lifetime income. “And as individuals live longer…the needs for their retirement, and having a very stable and reasonable retirement income, are becoming more and more important. “When you look at the demographic steamroller that exists in Australia, we’ve got an ageing demographic. We’re going to see a rapid growth in the segment of the population that’s 65 or older. “Along with that, individuals are living longer – so, [we have] a growing, aging demographic that’s going to have to produce real good income out of their retirement savings.
“As a result of the GFC a real new risk has been identified, and that’s market risk. When you get to be in your mid-50s and going towards retirement, when you have a precipitous market drop … it’s hard to make up, it’s hard to have your retirement assets grow as quickly as possible because you’ve only got a very short duration of time to have those assets grow – as a result, that’s a risk you have to protect against.” Stout says guaranteed income products have been available before, but lacked a couple of the key characteristics of the latest generation, including, most notably, access to capital at any time during retirement. “Individuals really want income guarantees,” he says. “They want the ability to have a guaranteed income that they can’t outlive.
But on the other hand they do not want their assets totally taken out of their control to generate that income. In particular that’s a trait of baby boomers.” Stout says it’s now up to financial planners to figure out how to best use the products for their clients. “It’s not that an individual should put all their assets in a product such as this, but if you can use products such as this in your overall planning, to take a portion of your assets, to be able to guarantee a monthly cheque to you, it gives you more security in retirement – and more and more folks will look to do that,” he says. “As you live longer you are going to need elements of growth assets in your inancial plan, but a portion of your assets put away in one of these structures gives the individual protection against outliving their assets.” This tim e it ’s diff erent The environment that exists for people retiring today, or in the “critical zone” are largely unparalleled.
As a corollary, opportunities for inventive and innovative product solutions are high. AXA says that the last big market crash, in 1987, had nowhere near the same impact on retirees as the GFC has had – and will have. In 1987, AXA says, the dominant retirement income product was the guaranteed annuity. A greater number of people were members of defined benefit funds, so a market crash was in some ways irrelevant to them. There was a much greater acceptance of the fact that in retirement an individual’s sole source of income would be the Aged Pension. And most individuals had minimal sharemarket exposure anyway. Fast-forward 20-something years, and the landscape has changed significantly. The dominant retirement income product is the allocated pension. Most people are members of defined contribution funds. The Superannuation Guarantee means many more people have superannuation than two decades ago, and many more investors bear the full impact of sharemarket movementsboth up and down. There are products available that offer guaranteed income for life, but they have one significant drawback: if a retiree buys such a product and dies, the issuer keeps the remaining capital.
Hedging the key A key to the new generation of retirement income products is a process called dynamic hedging which, while not a new concept to the institutional market, is a relatively new idea of the retail market. It’s being pitched to retail investors and their advisers as “insurance for your retirement income” – the fee charged for the guarantee is likened to an insurance premium. The issuer takes the guarantee fee and uses it to offset its liability, using futures contracts. But the products also rely on careful risk management. In the case of the ING product, for example, risk management has four dimensions: 1. Product design: Asset allocation restrictions & age specific payouts, biennial ratchet, fund switch restrictions 2. Capital market dynamic hedging: Sophisticated dynamic hedge program designed to optimise return over capital and ensure policyholder obligations are met with high probability 3. Reserves and capital: Regulatory reserves plus additional capital to meet rating agency requirements 4. Underlying fund selection:
Optimal fund selection together with targeted asset allocation designs aimed at minimising volatility risk and maximising “hedgeability”. The minimum income level is set relatively low – around 5 per cent of the fund value. So it’s not likely to be the sole source of income for a retiree; rather it is being promoted as a core, reliable income source, which can be supplemented with other, non-guaranteed (and hence potentially volatile) sources of income. In addition, there’s the issue of the cost of the guarantee. For the North product, for example, the cost can range from 90 basis points a year, to 295 basis points a year, depending on the investment option and term chosen. Generally speaking, the cost of the guarantee is higher for short terms and high growth asset exposures. The guarantee is cheapest when investors choose the longest term (20 years) and the lowest exposure to growth assets.
There’s also a question whether capital guaranteed products are a fad, or at least a creature of their times. Certainly appeal and demand is greatest when market conditions are or have been poor, like during the past two years. It remains to be seen whether demand will still be as high in , say, 10 years’ time if investors have had another decent run of investment returns. The “rising guarantee” feature of the new products is designed to combat the potential loss of appetite. Str ess testing The ultimate test of an income guarantee is to stress-test the product under extreme market conditions, using real market data. Figures provided by ING Australia show how the MoneyForLife product would have performed had it been available and had an investor used it in 1927, immediately before the market crash. If an individual put $200,000 into the fund, right before the market crashed, that initial figure would have been used as the “protected income base’ for the individual’s lifetime.
So even though the 1929 crash decimated investors’ capital (in fact, it did worse than decimate capital), the new-breed of retirement income products would have continued to pay a minimum of $10,000 a year income for the remainder of an individual’s life. If the same individual had invested $200,000 in the product at age 65 in 1982, the protected income base would have ratcheted up over time, reaching a peak of almost $600,000 by age 81. At that point the guaranteed income level would have climbed from $10,000 a year to $30,000 – a figure that was then locked-in and guaranteed for the past 10 years, right through the GFC up to today. (If the value of the fund were to subsequently grow to more than its previous peak, the guarantee would again ratchet up.)
Slow beginning After a relatively slow take-up of the guaranteed income concept, AXA says the product has more recently been well supported. “We had a fairly slow start, from the beginning in November 2007 though to the mid-point of November 2008,” says Adrian Emery, general manager of sales and marketing for AXA. “What we’ve seen in investment markets since the mid-point of 2008 and the second half of 2008 is a dramatic upturn in these types of products. “I’m tipping that by the end of this year we’ll go through $1 billion of funds flow in this year alone. “Clearly this is a product that clients and advisers alike are finding is working for them in a marketplace that has not only seen decline, but also as markets have stated to rise.
Capital protection isn’t just about falling markets; it’s also about rising markets. “We’ve now got more than 2000 advisers actively supporting the AXA North product, out of a marketplace of … probably 15,000 to 16,000 advisers.” Emery says capital guaranteed income products available today might look quite different from those in future as the concept is refined and developed. “The capital guaranteed/capital protected marketplace is a rapidly evolving area, with a whole range of players and products coming to the market, being managed in different ways, providing different types of solutions for clients, different types of investment portfolios, and one of the things that I do find interesting, when I read commentary about structured products, is just how diverse and wide the market is, from a manufacturer’s point of view,” Emery says. “From a consumer’s point of view, they’re probably looking for the same kind of thing: How do I make sure I protect the value of what I have built? How can I make sure I do not lose money going forward? How can I lock in some of the growth I’ve been making? How can I make sure I get income for the rest of my life?
“But from a manufacturer’s point of view we tend to provide those things in many different ways. Being part of a global group is what’s enabled us to provide it in what we believe is the most client-friendly, most flexible way that enables them to retain some degree of liquidity they are not able to retain in some of the other structures. “It also enables us to provide the guarantee in a way that ensures we provide the guarantee rather than the client self-insuring against the risk by buying and selling assets.” Emery says that for the time being, at least, demand from the retail market and the financial planning community for income guarantees remains high. “Having spent a long time building up assets, people have a natural aversion to seeing it reduced,” Emery says.
“We do think this is a marketplace that is perhaps in its infancy still in Australia. It’s been more developed in other parts of the globe, we believe, and that is to do with the level of adviser interaction with clients in Australia. Now what we’re seeing is many advisers recognising there is a place for capital guaranteed structured products as part of a client portfolio – perhaps not as the whole solution to a client portfolio, but certainly as part of a portfolio. “We’re seeing more and more advisers now asking us how do these work? What are the client benefits? How exactly do they help the client? What are the pitfalls? “That’s where we believe we need more transparency around the types of structures you’ve got and how they work. “We think we’re going to see more competitors come to the marketplace. Some are going to come with similar structures to the way we do it; other competitors will come with different structures.”