Measuring total portfolio outcomes when allocating an amount to a lifetime income stream
By Andrew Lowe , Head of Technical Services
Solving for the challenges of retirement with a portfolio allocation to a lifetime income stream
The Government’s Retirement Income Covenant (the Covenant) has been effective since 1 July 2022 requiring superannuation fund trustees to formulate, review regularly and give effect to a retirement income strategy. That strategy must address how trustees will assist members to achieve and balance the following objectives:
• to maximise expected retirement income over the period of retirement;
• to manage risks to the sustainability and stability of retirement income over the period of retirement including longevity, investment and inflation risks, and any other risks to the sustainability and stability of the retirement income; and
• to have flexible access to expected funds over the period of retirement.
While the Covenant does not directly impact the provision of advice to clients by advisers, many advisers have long sought to provide advice that balances these, and other, objectives. These challenges, after all, are nothing new. Some advisers have also sought to more specifically call out these elements of their advice in a post-Covenant world.
To balance these objectives, we have seen advisers support a partial allocation to a lifetime income stream. That allocation may be to a guaranteed CPI-linked (or similar) lifetime income stream, to a market-linked lifetime income stream, or to a combination of these lifetime income streams.
These lifetime income streams can directly help manage longevity risk with payments that will continue no matter how long a client lives. Lifetime income streams can also help in managing other risks clients are exposed to in retirement to varying degrees depending on the type of lifetime income stream.
Lifetime income streams can also help improve the likelihood of a client meeting their income goals, improving confidence to spend in retirement.
Finally, and perhaps often overlooked as a benefit of lifetime income streams, a partial allocation to a lifetime income stream can help to improve estate outcomes for clients.
Modelling a portfolio allocation to a lifetime income stream
The introduction above makes some strong claims about the benefits that a partial allocation to a lifetime income stream can bring to clients.
To assist advisers model a portfolio allocation to a lifetime income stream, Challenger makes available to advisers the Challenger Retirement Illustrator. The Challenger Retirement Illustrator is available via the Challenger Adviser Online Portal and can be found here:
A comprehensive Illustrator User Guide can be found here:
The Challenger Retirement Illustrator assumptions can be found here:
The Challenger Retirement Illustrator assists you with understanding how a comprehensive lifetime portfolio may change a client’s retirement outcomes.
The Challenger Retirement Illustrator uses information you enter (such as your client’s personal information) to:
• show the composition of retirement income over time from superannuation savings, Age Pension entitlements and other investments;
• demonstrate how combining a lifetime income stream into a retirement portfolio can help to manage the impact of markets on retirement income;
• illustrate how long retirement income is likely to last in different market scenarios;
• highlight the impact inflation can have on retirement income;
• show how choices made today can impact future income;
• provide estimates of the pre-tax value of a portfolio over time. You can choose to illustrate the amount payable on voluntary withdrawal or the amount payable in the event of death; and
• produce a lifetime retirement portfolio illustration which you can give to your clients as part of your own advice.
The Challenger Retirement Illustrator also provides access to the Challenger Age Pension Illustrator which can assist you with understanding how a client’s Age Pension entitlements may change when using a comprehensive lifetime portfolio. The Challenger Age Pension Illustrator uses information you enter to:
• estimate Age Pension entitlements;
• show how incorporating a lifetime income product can change Age Pension outcomes; and
• produce an illustration which you can give to your clients as part of your own advice.
Measuring total portfolio outcomes when allocating an amount to a lifetime income stream
Total portfolio outcomes driven by a partial allocation to a lifetime income stream vary by client. However, by using a relatively typical client scenario and modelling these total portfolio outcomes, it is possible to understand the value of such benefits available.
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Introducing Bora and Bryce
Bora and Bryce are a 67-year-old couple. They have recently retired. They’ve worked hard and are now looking forward to having a whole lot more time to do the things they love. They are active, interested and involved.
Bora and Bryce own their own home and are free of debt. They have $500,000 each in superannuation that they are considering transferring to account-based pensions to start funding their retirement income. Their super (and any future account-based pension) is invested in accordance with their 50/50 growth/ defensive risk profile. They have $50,000 in cash and term deposits and $20,000 worth of personal assets.
Bora and Bryce would like to live comfortably for as long as possible and estimate that $70,482 p.a. (equal to the ASFA March 2023 quarter ‘Comfortable’ retirement standard), indexed each year with inflation, would be sufficient to meet this goal. As part of their total intended annual spend in retirement Bora and Bryce have established that they require at least $45,808 p.a. (equal to the ASFA March 2023 quarter ‘Modest’ retirement standard), indexed each year with inflation, to meet their essential spending requirements in retirement.
Base case modelling: Account-based pensions only
Base case modelling for Bora and Bryce aligns with their initial thoughts of simply rolling over their superannuation to account-based pensions and investing in accordance with their 50/50 risk profile. The analysis of this alternative (shown in the graph below), with Bora and Bryce drawing $70,482 p.a. (adjusted for inflation) from all sources sees their account-based pensions projected to last until age 100, and well beyond their couple life expectancy of age 94 (when one of both is expected to be alive).
This is a strong looking deterministic projection of the retirement income for Bora and Bryce (the spikes above their target income are a result of higher superannuation minimums and this excess income is assumed to be added to and saved along with their other cash holdings). However, it is a simple analysis which fails to address the likely volatility of investment returns over time. We know, for example, that whilst we might achieve the projected rates of return over time, variation in the actual returns from year to year could significantly change retirement outcomes.
As, in reality, investment returns are never constant, the Challenger Retirement Illustrator allows advisers to stress test both an account-based pension only portfolio and the comprehensive lifetime retirement portfolio using returns that change over time. To do this, we model and analyse 2,000 market scenarios over 40 years (stochastic modelling). Each market scenario has different asset class returns and related market indicators such as the level of inflation. The market scenarios are provided by Moody’s Analytics and are generated using the Moody’s Analytics Scenario Generator. The scenarios are designed to be representative of how real-world markets could behave in the future. The stress test enables a direct comparison of how a comprehensive lifetime retirement portfolio performs compared to an account-based pension only portfolio under a range of different market conditions.
When we test this strategy for Bora and Bryce, we find a high likelihood that both their income ‘needs’ and their ‘income needs and wants’ will be met over their life expectancy as shown on the dials below.
So, this base case analysis appears relatively robust for Bora and Bryce. The question isn’t, therefore, is this strategy broken, but, instead, can we do better? Can we provide more certainty to Bora and Bryce around their retirement income?
Enhanced modelling: Improving retirement income outcomes with a CPI-linked lifetime annuity
The enhanced strategy modelling for Bora and Bryce involves a blend of both account-based pensions and a 20% allocation to guaranteed CPI-linked lifetime annuities. In this case the strategy involves a re-balancing of the asset allocation of the account-based pensions to ensure that the allocation to the CPI-linked lifetime annuity does not ‘de-risk’ Bora and Bryce’s investments.
This enhanced strategy, represented in the graph below, helps extend the expected duration of Bora and Bryce’s account-based pensions.
The stochastic modelling shows, in the dials below, the improved likelihood of meeting Bora and Bryce's income objectives with extremely high likelihood of meeting these goals. This enhanced strategy can increase the confidence with which Bora and Bryce can spend in retirement.
This enhanced strategy is also likely to improve estate outcomes for Bora and Bryce.
The chart below represents the median estate (bequest) value based on the 2,000 market scenarios.
While at different points, either strategy might provide a higher estate value, at life expectancy, for example, the strategy allocating 20% of assets to the lifetime income stream provides a higher estate value.
To summarise, for Bora and Bryce, a 20% partial allocation to a lifetime income stream provides:
• Lifetime income, fully indexed for inflation, for as long as they live. The lifetime income amount in the first year is $10,326.
• A 100% chance of meeting income ‘needs’ (an increase of 13% over the non-lifetime portfolio).
• A 93% chance of meeting desired ‘needs and wants’ (an increase of 10% over the non-lifetime portfolio).
• Total retirement income paid over 27 years increased by $80,256 (in today’s dollars).
• The estate value at the end of 27 years increased by $75,919 (in today’s dollars).
Lifetime income streams can directly help manage longevity risk with payments that will continue no matter how long a client lives. Lifetime income streams can also help in managing the other risks clients are exposed to in retirement to varying degrees depending on the type of lifetime income stream.
Lifetime income streams can also help improve the likelihood of a client meeting their income goals, improving confidence to spend in retirement.
And, finally, a partial allocation to a lifetime income stream can help to improve estate outcomes for clients.
The Challenger Business Development team can assist advisers looking to model the benefits that a partial allocation to a lifetime income stream can bring to clients.
Assumptions: All projections sourced from the Challenger Retirement Illustrator (05/06/2023) using Social Security rates and thresholds effective 20 March 2023. 67 year old male/female homeowner couple. $500,000 each available for investment via account-based pension and partial (20%) allocation to a Challenger Lifetime Annuity (Liquid Lifetime) with immediate payments linked to CPI and no adviser fees. Super asset allocation 50% growth/50% defensive. Assumes returns of 4% p.a. for defensive assets and 8% p.a. for growth assets before fees. $50,000 cash/TDs earning 4% p.a. interest. Personal assets of $20,000. $70,482 p.a. desired income including $45,808 p.a. essential income. Amounts shown are in today’s dollars. CPI of 2.5% p.a. See Challenger Retirement Illustrator for all assumptions. Challenger RIC reference: RIC230605000050. Rates subject to change.
The information in this article is current as at 1 June 2023 unless otherwise specified and is provided by Challenger Life Company Limited ABN 44 072 486 938, AFSL 234670 (Challenger, our, we), the issuer of the Challenger annuities (Annuity(ies)) and Challenger Retirement and Investment Services Limited ABN 80 115 534 453, AFSL 295642 (CRISL). The information in this article is general information only about our financial products and is intended solely for licensed financial advisers or authorised representatives of licensed financial advisers, and is provided to them on a confidential basis. It is not intended to constitute financial product advice. This information must not be distributed, delivered, disclosed or otherwise disseminated to any investor, without our express prior approval. Investors should consider the applicable Annuity Target Market Determination (TMD) and Product Disclosure Statement (PDS) available at challenger.com.au and the appropriateness of the applicable product to their circumstances before making an investment decision. This information has been prepared without taking into account any person’s objectives, financial situation or needs. Neither Challenger and/or CRISL, nor any of its officers or employees, are a registered tax agent or a registered tax (financial) adviser under the Tax Agent Services Act 2009 (Cth) and none of them is licensed or authorised to provide tax or social security advice. Before acting, we strongly recommend that prospective investors obtain financial product advice, as well as taxation and applicable social security advice, from qualified professional advisers who are able to take into account the investor’s individual circumstances. Each person should, therefore, consider its appropriateness having regard to these matters and the information in the Target Market Determination (TMD) and Product Disclosure Statement (PDS) for the applicable Annuity before deciding whether to acquire or continue to hold the product. A copy of the TMD and PDS is available at challenger.com.au or by contacting our Adviser Services Team on 13 35 66. Any examples shown in this article are for illustrative purposes only and are not a prediction or guarantee of any particular outcome. Age Pension benefits described in this article will not apply to all individuals. Age Pension outcomes depend on an individual (or couple’s) personal circumstances and may change over time. This article may include statements of opinion, forward looking statements, forecasts or predictions based on current expectations about future events and results. Actual results may be materially different from those shown. This is because outcomes reflect the assumptions made and may be affected by known or unknown risks and uncertainties that are not able to be presently identified. Where information about our products is past performance information, past performance is not a reliable indicator of future performance. Challenger and CRISL relied on publicly available information and sources believed to be reliable, however, the information has not been independently verified by Challenger and CRISL. While due care and attention has been exercised in the preparation of this information, Challenger and CRISL gives no representation or warranty (express or implied) as to its accuracy, completeness or reliability. The information presented in this article is not intended to be a complete statement or summary of the matters to which reference is made in this article. To the maximum extent permissible under law, neither Challenger, CRISL, nor its related entities, nor any of their directors, employees or agents, accept any liability for any loss or damage in connection with the use of or reliance on all or part of, or any omission inadequacy or inaccuracy in, the information in this article. Challenger Life and CRISL are not an authorised deposit-taking institution for the purpose of the Banking Act 1959 (Cth), and its obligations do not represent deposits or liabilities of an authorised deposit-taking institution in the Challenger Group (Challenger ADI) and no Challenger ADI provides a guarantee or otherwise provides assurance in respect of the obligations of Challenger Life. Accordingly, unless specified otherwise, the performance, the repayment of capital and any particular rate of return on your investments are not guaranteed by any Challenger ADI.
Financial Adviser & Director | Financial Planning and Advice
1yThank you for sharing Andrew. Have sent you a pm...