Even with a good retirement fund, the risk of running out of money before you die is real

Keith Richards is now 71 and still working. Photo by Michael Hickey/Getty Images

Start talking to most people about superannuation and their eyes glaze over.

The reality is we are all living longer and people – and governments – around the world are grappling with the impact increased life expectancy is having at a personal and at a societal level.

None of us want to work hard all our life only to be poor at the end of it. That means the two big questions people have to answer at some point are:

  • how long will I live?
  • will I have enough money saved to make it to the end of my life?

The second question, with us living longer, is a talking point in finance now and it’s about what pointy-headed types call “longevity risk”.

Put simply, the term refers to the chance that you’ll run out of money before you die.

That’s the focus of a new report, The Challenge of Longevity Risk – Making retirement income last a lifetime, jointly published by the Actuaries Institute of Australia, The Institute and Faculty of Actuaries in the UK, and the American Academy of Actuaries.

The report highlights that because most retirement savings plans have changed from those sponsored by governments or companies (defined benefits) to those where the amount of saving, asset allocation and market returns determine how much cash people have in retirement (defined contribution) that it’s up to the individual to manage “longevity risk — alongside investment and inflation risk — to the individual”.

The report also explains:

As people save, and subsequently come to spend their retirement income, investment, inflation, and personal spending risks (such as long-term care needs) are incredibly important. Longevity presents another critical risk, particularly around the risk of living to very advanced ages with depleted financial assets.

That’s a future many of us might face either through lack of savings or because of spending decisions or incidents in retirement.

Take a recent report in the AFR showing that a survey of 1000 members over 50 conducted by the Retail Employees Superannuation Trust (an industry fund) found “nearly three-quarters of older working Australians with adult children are planning to help them financially, primarily by drawing down from their superannuation balances on retirement”.

As laudable as that is in the current environment of high house prices, it mistakes the purpose of superannuation, which federal treasurer Scott Morrison has on more than one occasion felt the need to underline is for retirement income. In May, when he was still social services minister, Morrison told Baby Boomers to spend the kids’ inheritance.

Damian Hill, the CEO of the fund which undertook the survey, agreed with Morrison. He said: “We would urge retirees not to forget that their retirement savings are first and foremost meant to fund their own retirement, and using retirement savings for other purposes may mean they become a financial burden on their own children later in life”.

That’s all well and good but exactly how long are we going to live and how much money do we need to put away in the current environment to make sure our cash last till our end of days?

5 principles for matching your money with your mortality

The authors argue:

In light of the mutual recognition by our respective legislators that it is important to encourage people to save for a pension and make choices at retirement that should lead to a sustainable income, we believe there are at least five principles for developing policy on DC decumulation (when savings are being drawn down and spent).

Those 5 principles are as follows.

The adequacy of the structure of the system around retirement savings, that it’s fit for purpose, and the ability of workers and retirees to understand what is an “adequate income” is principal number one.

Information is also important and the report says workers need to understand that average life expectancy is different to their own mortality. This needs to be taken into account and the information needs to be freely available at the decision making process for savers and updated the report says for changes in mortality rates.

As people and technology change, as investment options morph and the life cycle of retirement changes so the system needs embedded flexibility. This is the third principle. The authors prefer a system where regulation is,”sufficiently flexible to reflect individuals’ different retirement needs, changing circumstances, and their varying capacity to exercise choice. A critical issue is flexibility during retirement to allow people to adjust their arrangements to suit changing circumstances.”

Crucially the report notes that “a flexible regulatory framework should also support innovation.” Which is another warning that Australia’s superannuation system shouldn’t swing too far toward prescriptive policy.

The fourth principal is an interesting, perhaps contentious one: equity.

The authors of the report take aim at the low interest rate policies being run by central banks around the globe and the impact that has on savers and retirees. This has crushed the returns you can get on money by parking it with a bank.

They call it “fairness” and note that “governments and central banks need to be mindful of the impact of monetary policy on products that lock into the current interest rate environment,” the report says.

That’s a theme picked up recently by Blackrock’s global chief investment strategist Ross Koesterich who told the Wall Street Journal that the “amount of money you need to generate a certain level of income is a lot higher than it used to be.”

That, Koesterich said means that even after saving for decade workers might be in for “a very unpleasant surprise.”

Sustainability is the fifth principle. Meddling and tinkering by governments is unhelpful. The report says:

Sustainability of the retirement market over a number of generations would provide clarity to solution providers. More importantly, changes that focus on the longer term and do not encourage “tinkering” with existing systems would also offer clarity to the population at large.

But sustainability also means the system has to be cost-effective, which will “require an efficient system, in that one’s overall level of expenses will have to be sufficiently low to make it economically viable,” the authors note.

Barriers to efficiency the report says are, “excessive commissions, high investment and/or administration fees and not taking advantage of the economies of scale.”

These are things the Australian government has already been grappling with via the FSI and other legislative initiatives.

Making it happen at an individual level

The five pillars of a strong system make sense if adopted by government who would then need to ensure that workers and retirees are empowered with information to make the right choices at retirement.

But in the end, retirees still have to make a decision on what they are going to do with their savings and how they want to allocate them.

Some will argue that taking some sort of pension from accumulated savings is the way to go. The Murray financial system inquiry advocated increased use of Comprehensive Income Products for Retirement (CIPRs). This week Challenger and three industry super funds have announced that they have partnered to provide members with such products. But in its submission to the FSI Challenger highlighted that one size does not fit all.

But, CIPRs are not the only way to go. State Street Global Advisors (SSGA) has launched a product range based on the a life cycle based approach to asset allocation before and after retirement.

Retirement then has different stages – the active period, the less active period, and then the older age period of retirement. Each has differing financial characterisitics. SSGA is seeking to manage longevity risk and navigate the minefield of uncertain returns and life expectancy in retirement.

Mark Wills, State Street Global Advisors’ Asia Pacific head of the Investment Solutions Group told Business Insider that considering retirement is analogous to computer industry software development.

If you want to get some software written there are three variables around the software; quality, cost and time. You can only pick two of the variables i.e. if you want a quality piece of software then you can have it quickly but it will cost more or you can wait and it will cost less. Cost and time are mutually exclusive.

Likewise, retirement savings offer three variables, Wills said. Asset allocation (which markets you put your money in), drawdown (the volatility in that market and risk that asset prices fall), and longevity.

But, like the computer software analogy, you can only have two.

So if you say that you want to have a static asset allocation then if you want your money to last you have to experience large drawdowns as you will be heavily exposed to risk assets. If you want a static asset allocation and you don’t want a drawdown then you will run out of more and so cannot manage longevity as you will be more exposed to low risk assets.

If you want your money to last, solve longevity, and not have a drawdown, then you have to change your asset allocation, radically, to protect the fund from increased market volatility which is when risk assets damage the returns of your portfolio.

The point is that by not taking such an active approach to savings management, many people are faced with a bleak outlook for their retirement.

Wills said that when SSGA used its advanced mathematical models to perform a Monte Carlo simulation (which ran a huge range of variables, over multiple time frames, in a large number of simulations to generate probable outcomes) “9 out of 10 people ran out of money.”

Ninety per cent of us outliving our savings just because we didn’t plan properly is a scary proposition.

Clearly the actuaries who authored this longevity report are onto something.

NOW WATCH: Money & Markets videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.