Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Why Frontier think it’s made a retirement ‘breakthrough’
Frontier styles its latest piece of retirement research, released on Friday, as a “breakthrough” that could help members in retirement live a more fulfilling and secure post-working life. Given the way the system works currently, that may well be the case.
Current fund designs inadvertently minimise, rather than maximise income for retirees because many of them draw down at the minimum rate. That rate is set by the government to ensure the wealthy don’t park large amounts of money behind the tax treatment of superannuation; it’s not meant to be a default, Frontier says, but around half of members use it that way.
“We work out that about half of members are drawing down at the minimums, which are an age based amount… if you’re 67 it’s five per cent, and that’s an easy thing for the fund and members to do,” Frontier senior consultant David Carruthers tells ISN. “But it makes sure that they minimise the income rather than maximise the income.”
It also provides higher income in later years, leads to a more variable income based on market movements, and results in retirees leaving large bequests. That’s fine for somebody who wants to leave a large bequest and has significant assets outside of super, but only 10 per cent of members in a Frontier survey prefer that approach. Almost three quarters of members want “regular income for lifetime with some flexibility”.
The Frontier fix is (relatively) simple; what Carruthers describes as a “modestly complex” calculation based on balance, age and life expectancy. The beauty of it is that it produces something that is both more coherent to members and allows them to budget their income more effectively.
“It’s about replacing somebody’s pre-retirement wage with a post-retirement wage, providing them with a flat dollar amount every fortnight – something they can budget on, rather than a variable amount,” Carruthers says. “The important thing with that is you’ll want to recalculate it every year because investment markets go up or down.”
But members living on the smallest amount of money possible has one benefit: they’re unlikely to run out of money. Carruthers concedes that the retirement wage concept could introduce a level of longevity risk into the retirement income stream that isn’t present when members scrimp, and that depending on how funds implement it, it might stray into the arena of personal advice; what should be a mass customisation exercise instead gets bogged down in “the rigmarole of SOAs”.
“If you do it in a more personalised manner than you’d be in the world of personal advice,” Carruthers says.
But the way things are done currently contrasts with “the essential obligations” of super funds to provide the best possible outcomes for members.
“Encouraging members to draw down at minimum rates will result in a poor outcome for many members,” Carruthers says. “By definition, it minimises income, impacting their quality of life, especially during the active early years of retirement, making budgeting challenging due to income variability.”
