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From 1 July 2022 the retirement income covenant (the Covenant) will require Australian superannuation fund trustees to develop a retirement strategy for members and publish a summary on their website. The covenant requires trustees to:

• maximise expected retirement income over the period of retirement;
• manage market, inflation and longevity risk; and
• balance flexible access to savings

SMSF trustees were carved out of the legislation. They have an existing investment strategy operating standard under SIS Regulation 4.09 which requires the trustees to formulate, review regularly, and give effect to an investment strategy that has regard to the whole of the circumstances of the fund. The requirements include considering the risks and liquidity involved in the fund’s investments, having regard to objectives and cash flow requirements. This is aligned with the requirements of the covenant now imposed on other superannuation fund trustees.

What will the covenant mean for retirement advice?

The competing and complex objectives of the covenant have historically been achieved for retirees through financial advice. Super funds will now be creating solutions which look to achieve these objectives for members. However, financial advice continues to offer retirees something that the strategies offered by super funds will not. Personalisation.

A key idea of the covenant is that a one-size fits all approach may not achieve the objectives, and trustees are expected to analyse their membership and understand if different retirement strategies might be required to achieve the objectives for different cohorts of members. That is, strategies may be developed based on key characteristics such as Age Pension eligibility or level of savings.

Solutions designed for cohorts of members may improve upon the status quo but is not expected to deliver the optimal solution for any individual member. Personal financial advice remains in the box seat to develop a strategy personalised for a retiree’s individual circumstances and objectives.

Most financial advisers will already consider how to manage risk, maximise income, and balance flexibility to achieve a client’s goals for retirement. However, to showcase the value of their advice it may become important to think about how to evidence those considerations. Super fund trustees are engaging professionals such as actuarial consultants to undertake sophisticated and comprehensive retirement modelling to comply with the covenant and develop retirement strategies for cohorts of members. However, there is no reason why financial advisers cannot access similarly sophisticated tools to evidence the benefits of their personalised retirement strategies.

Comprehensive retirement models to support advice

Retirement is complex and an adviser needs to be able to make a holistic assessment of market, inflation, and longevity risk on the outcome of a retirement strategy.

An approach still widely used in advice is deterministic modelling. This uses fixed assumptions e.g. 5% p.a. investment return, to model outcomes such as cashflows and balances. However, this does not allow an adviser to illustrate how a strategy manages risk, as there is no variation in return or inflation assumptions, and typically a fixed timeframe is considered.

A stochastic modelling approach involves analysis of the range of possible outcomes by considering thousands of simulations to stress test the likelihood of a strategy achieving a client’s goals. This more sophisticated approach allows an adviser to understand and evidence how a strategy manages risk.

Think about the common retirement planning question: what is an affordable level of spending? What a retiree can spend will depend on the sequence of returns actually achieved and how long they actually live, neither of which is known in advance. Instead, a model is used to determine an answer:

• A spend determined using one possible path of returns (deterministic model) will likely be wrong, and the adviser will have no measure of how wrong. E.g. a client can afford to spend $50,000 p.a. for 25 years based on a 6% p.a. investment return and 2.5% pa inflation… but the adviser knows the client won’t get positive 6% p.a. every year for 25 years, and any other fixed set of returns won’t be realistic either.
• A spend determined using a thousand possible paths of returns (stochastic model) which represent the expected distribution of returns and inflation, including paths with negative returns like the GFC, others with good returns, and everything in between, allows for real-world volatility and risk. E.g. if a client spends $50,000 p.a. there is a 60% chance it will last for life… the adviser can assess whether the risk that spending will run out is acceptable.

The Actuaries Institute recently released guidance on what to look for in a retirement model which you can read here: Information Note: Good Practice Principles for Retirement Modelling

Accurium’s retirement healthcheck

Accurium has developed a comprehensive model of retirement specifically to help individuals make decisions about retirement strategy. We have taken our sophisticated stochastic actuarial model more commonly used for corporate consulting work and developed a user friendly front-end designed to help professionals evidence how retirement strategies manage risk.