It’s now 23 years since Approved Retirement Funds (ARFs) were introduced in the Irish market, giving people choice on the use of their pension pots in a way that didn’t exist before. There was a lot that was good about this, but with choice comes complexity and there are other trends adding to that complexity.
In those 23 years, according to the Central Statistics Office, mortality rates have improved to the extent that life expectancies from age 65 have increased by somewhere around three years.
Other social pressures are also weighing heavily on those who come into possession of their retirement funds. Not least among the challenges is the growing trend in adult children leaning into their parents for support in getting on the housing ladder. There is a natural tendency in parents to help if they can, and the arrival of a tax-free lump sum or even the access to taxable withdrawals can perhaps give an overstated sense of their ability (and perhaps even a responsibility) to do so. At a recent meeting of the Editorial Committee, we debated whether our advice processes and products in relation to the use of retirement funds have adapted sufficiently to meet this growing complexity.
Helping Clients Clarify Their Needsin Retirement
A number of years ago I sat on a working party that focused on post retirement products. Several of my colleagues argued for Master Trust arrangements for ARFs that could keep costs down (similar to the efficiencies achieved in large group retirement saving schemes). I wasn’t so sure though. As I saw it, the thing that allows for efficiency in group pre-retirement savings is the great commonality between the savers. Apart from transfers out, their money is locked in, and they are all typically aiming at the same retirement age. There may be some diversity in investment choices but that can be handled by a relatively small set of funds.
However, once retirement arrives, their needs scatter like seeds in the wind. They differ wildly in terms of health, wider wealth, dependants’ needs and risk attitude (not only in relation to how they invest, but in terms of comfort in spending money with an uncertain timeline). In my view, the need for tailored advice at this time, and by extension, tailored solutions, is huge.
There are of course some commonalities to their journeys. In the Postgraduate Diploma we debate the paper “A Holistic Framework for Life Cycle Financial Planning” produced several years ago by Joshua Corrigan and Wade Matterson of Milliman. They break up people’s retirement into three stages. In the years immediately after retirement (Active Retirement as they call it) the expenditure needs of people may be higher than in the years running up to retirement, as they are suddenly time-rich, and may want to work through
their bucket list. As people move through their 70s, they can transition into a stage called Passive Retirement, where energy can dissipate somewhat, and spending needs may reduce. Finally, typically in the late 80s, for most, health gradually deteriorates, and spending can turn to core needs and perhaps higher medical expenses.
their bucket list. As people move through their 70s, they can transition into a stage called Passive Retirement, where energy can dissipate somewhat, and spending needs may reduce. Finally, typically in the late 80s, for most, health gradually deteriorates, and spending can turn to core needs and perhaps higher medical expenses.
Effective post-retirement strategies should recognise these various stages to ensure clients get the most enjoyment from their money. For example, if someone put all their retirement money into an indexed annuity, this would effectively back-end their spending power, arguably the exact opposite of what they need.
I guess the question is, how effective are our advice tools in bringing out clients’ individual intentions/desires and overlaying them with the typical journey to arrive at a sensible spending pattern?
Helping People Truly Understand Their Product Choices
How good are we in helping clients truly weigh up the product choices available to them – particularly in relation to annuities? The impact of the launch of ARFs on the annuity market was almost immediate and impacted in many ways.
It was perhaps an unfortunate coincidence that the introduction was closely followed by the introduction of the euro, which led to some suppression of interest rates, to be followed 10 years later by the period of ultra-low interest rates that is only now showing signs of ending.
This led to an increase in the price of annuities which made them seem unattractive.
The improvements in longevity over the last 40 years have further damaged the attractiveness of annuities. The fact that the price increases from this source are simply because annuities need to pay out for longer are typically lost on the public. Their focus (naturally enough) is on the relatively small amount they will get back if they die in the first 10 years (regardless of how unlikely that is).
If that wasn’t bad enough, people with impaired health (who up until 1999) were forced to buy an annuity now (quite rightly) buy ARFs. Very good for them of course, but it meant that the subsidy that they previously would have provided to healthier lives in the pooling of risk was no longer there, further pushing up the price of annuities.
The thing is, the price of annuities reflects the cost of providing an income for life, assuming the money is invested very conservatively. If someone wants to do better than that, then they need to take risk. So that leads us to how they invest.
Investment Strategies
Clearly, many of the strategies that had been put in place when annuities were the only option are no longer appropriate. Lifestyling strategies that trended toward long-term bonds are great for those who want to buy an annuity, but totally inappropriate for those who plan to remain invested in an ARF.
In recent years I’ve seen the development of strategies established to better reflect the use of ARFs in retirement. But, to my eye, there has always been an inappropriate focus on retirement age as the target date, with significant de-risking as that day approaches. However, if a 60-year-old is planning to take an ARF, isn’t a significant portion of his or her money needed in 20 or 30 years’ time? With that in mind, shouldn’t a significant amount of funds be in assets with higher return potential? And if not, are customers essentially getting the same return as they would if they had an annuity, without the peace of mind of knowing that income will flow as long as they are alive?
I think this is a very difficult topic and full of risk for the client and the adviser. The obvious risk is that having a retiree in risky assets can be jumped on as being irresponsible by those who don’t quite grasp the length of time the money has to last, and the need for growth to both help it last, and to protect from inflation (it’s back!).
Finally, it must be said that developing an investment strategy is made even more difficult by the humanity of aging.
Behavioural and Capacity Issues
The impact of humanity on dealing with retirement money, both in terms of the tendency for irrational behaviour in relation to money, and its frailty as age progresses, can’t be overestimated.
As mentioned above, the mathematical truth of annuities simply can’t compete with the gut feeling of those who believe they are giving their money to a life company with the possibility (hugely overstated) of getting very little back. Similarly, a well-established phenomenon in the field of behavioural economics is known as the ‘Money Illusion’ and one aspect of this is the tendency to overestimate what a large euro amount can achieve. This can lead to inappropriate distributions at the early stages of retirement.
Many people become more conservative or even anxious as they get older. This can impact on their ability to enjoy spending (particularly in the absence of a guaranteed income) and/or become fretful about investments in growth assets (possibly leading to inappropriate decisions in times of market volatility).
Perhaps the most difficult aspect of this is providing for the event where the client suffers illnesses that impair their capacity to make appropriate decisions about their money. What provision is made for this in investment strategies?
Where to Next?
These are just a few aspects of the crucial and complex topic of financial planning at retirement. There are many others including tax effectiveness, interactions with estate planning, the use of the family home in retirement planning and so on.
I’m conscious this piece is big on questions and short on answers. However, as a committee, we plan to devote significant attention to this topic in the coming issues, sourcing the views of experts in the industry. If there is anything particularly that you’d like to see covered, you feel strongly about, or that you might feel you can contribute to, we’d be delighted to hear from you.
We hope to add value to your consideration on how you advise your clients on this very important topic and, given that we all hope to face the problem of making money last a long time, learn a little more for our own futures.