Superannuation: make income the outcome

The emphasis on the lump sum in superannuation unfairly moves risk to individuals. Image sourced from

Having led the world in the 1990s in embracing defined contribution retirement plans, Australia now is rightly reviewing whether the design of its retirement income system is meeting the needs of Australians living in retirement.

David Murray’s interim report into Australia’s financial systems noted the particular strengths of this three-pillar system, which comprises the age pension, compulsory superannuation guarantee and voluntary private savings. With more than A$1.8 trillion of assets under management, Australia now has the fourth largest private pension pool in the world. The questions, as the Murray report identified, are around the complexity, efficiency and efficacy of the system.

The fact is Australians are not only living longer, they are seeking greater choice and control in managing their retirement arrangements and need cost-effective products that meet their income needs over many decades after stopping full-time work.

The problems with the current system, as I see it, are two-fold: One is around the lack of meaningful information given to consumers and the other is around the stated lump sum goal of most superannuation plans. Unlike the old employer-sponsored defined benefit plans, the defined contribution (DC) plans that dominate in Australia and in the US market transfer the investment and other risks from companies to employees.

My view is that putting relatively complex decisions in the hands of individuals with little or no financial expertise is problematic. While some say the answer is increased financial literacy, it is simply unrealistic to expect people to make decisions about strategies that challenge even seasoned investment professionals. To use an analogy, when we service our cars, the mechanic does not expect us to be able to understand how the fuel injection system works. Most of us just want a vehicle that gets us safely and reliably to our desired destination.

It’s the same with our retirement plans. It really makes no sense to ask individuals to make complex choices about risk exposures and asset allocation, for instance.

The second problem is the goal itself. The language around DC investment is about asset value. People are trained to see the key metric as the size of their fund pool, when what really matters to them is whether they will have sufficient income in retirement to live the lives they want to live.

If an individual’s pension savings are invested to maximise capital value at time of retirement and her personal goal is to achieve a reasonable level of retirement income, there is a clear mismatch involved.

In the view of the superannuation fund, the relevant risk is portfolio value. But the risk for the individual is uncertainty around retirement income. How do we solve this dilemma? The answer is to adopt a liability-driven investment strategy that is equivalent to how an insurer hedges an annuity contract or how pension funds hedge their liabilities for future retirement payments to members. Nearly a quarter of a century since Australia moved to compulsory super, the financial technology now exists to invest individual super contributions this way. Each fund member would still get a pot of money at retirement and would still have the same choice over their savings they have under current DC arrangements. The difference is the value of the pot would be obtained through a strategy meant to maximise the likelihood of achieving the desired income stream.

Moving to this income-focused strategy would require changes not only to the way super plans actually invest their members’ money but also to how they engage and communicate with savers.

Instead of being asked complex (and meaningless) questions about asset allocation, members would be asked three simple questions – their retirement income goal, how much they can contribute from current income and how long they plan to work. Of course, the asset allocation is important, but this only a factor for achieving success. It is not a meaningful input for the choices the consumer actually makes. Once these variables are known, the fund need only regularly communicate to the member the probability of reaching her goal. To increase that probability, the fund member has only three choices – save more, work longer or take more risk. There are no other ways.

The gap between what exists and what Australians need was highlighted by the Murray inquiry interim report, which noted that the current focus on lump sum balances in the superannuation system is evident in the absence of retirement income projections from annual statements to members.

“For many people, income projections, while difficult to calculate, would be far more useful than total accrued balances,” Murray said.

As someone who has spent much of his professional life researching this issue, I can only agree. Ultimately, what Australia needs is an approach to superannuation that uses smarter products rather than trying to make consumers smarter about finance.