Designing a simple path to achieving retirement income objectives
Thought Leadership
Part 2: Introducing Asset Liability Management strategies and how it can be applied to balance income certainty and longevity protection in the retirement phase.
Previously we discussed the potential benefits of protection strategies in managing flexibility and capital protection during the early phase of retirement. At this time, access to capital and limiting the impact of drawdowns due to market volatility are both a high priority. As a brief recap, we explored the role protection strategies can play in protecting or reshaping return distribution to target a desired cash flow profile in a decumulation portfolio.
As members age, they tend to prefer increased certainty in investment returns, and are more averse to putting their capital at risk. While a degree of flexibility is still desirable, tighter control of return distribution and increased vigilance for capital protection can be beneficial for investment strategies for older retirees. In this article we’ll look at Asset and Liability Management (ALM), and how it can be applied to a portfolio to balance income stability and longevity protection in the retirement phase.
Asset Liability Management (ALM) Strategies
As a strategy that supports delivery of a cash flow profile with protection from the negative impacts of market volatility, Asset Liability Management (ALM) is an important solution for delivering certainty in a decumulation portfolio. A prudent ALM approach targets appropriate and expected cash flows, taking into account the underlying potential for volatility in an investment portfolio.
Using ALM principles to guide the decumulation process also makes it easier to manage other investment ‘trade-offs’. For example, it enables a clear focus on the goal of balancing the investment income and capital drawdown for cash flow. An ALM process can be combined with a framework for assessing the relative ability of potential investments to deliver the cash flows required.
To remove all investment risk, the ALM process could match all cash flows with government bonds, however, this would limit potential returns and might result in lower payments to the member. Taking some investment risk – combined with an ALM approach and managed appropriately – can deliver higher expected returns to maximise retirement payments while still providing income security.
Some investors take a passive ‘set-and-forget’ approach to an ALM strategy with the aim of capturing a risk premium over time. In our view, following a more dynamic ALM-aware investment approach is more effective and forms the solid base on which to build a decumulation strategy. This involves consideration of current opportunity sets across a range of assets while matching portfolio exposures to the target cash flow profile.
Introducing ALM techniques to secure cash flow and longevity protection
One way super funds can tighten the return distribution in retirement for members is to move away from an asset-only allocation approach and introduce an ALM strategy by integrating annuitisation into the overall retirement income product design.
Inclusion of annuitisation into the retirement income strategy enables a super fund to embed a guaranteed return stream with no volatility of income, as part of the overall retirement income strategy. Integrating this type of annuitisation should be funded from the defensive part of the portfolio to ensure the risk profile of the overall retirement income strategy remains consistent. The proportion of the portfolio that is annuitised can be refined depending on member preference and current conditions such as interest rates.
One way to achieve a tighter return distribution could be taking up term annuities which can be an effective choice for an ALM approach during early retirement. Term annuities deliver a higher degree of flexibility for partial return of capital to the member through guaranteed payments over a fixed term. Investors can tailor the residual value of the term annuity from 0-100.
There are two potential solutions that complement an investment portfolio for retirement income:
• A guaranteed annuitised solution through a ‘Group Annuity’
• A pooled income stream solution
With a guaranteed annuitised solution, an insurer underwrites the lifetime income and bears the longevity risk. With a pooled income stream, the members in the pool are sharing this risk. This is why the lifetime income provided by a pooled income stream cannot be guaranteed. The forecast lifespan of pool members is key in calculating distributions to members. If this forecast proves to be inaccurate, this can have a significant impact on members’ access to income.
There are other pros and cons to consider - for the fund and its members - for these two approaches, outlined in the table below:
Fund experience:
| Key considerations | Group annuity | Pooled Income Streams |
|---|---|---|
| Report on AUM | Super fund retains AUM. Super fund holds master policy as an asset, similar to allocating responsibility for investments to a third-party asset manager under an IMA. | Super fund retains AUM. Funds are typically managed by internal investment teams. |
| Set up costs | May enable implementation efficiency by reducing or avoiding capex. | May require in-house capability to build and manage the solution. |
| Speed to market | Leverage insurer’s balance sheet and capability for swift implementation for members. | Cost and complexity can slow down delivery of solution to members. |
| Simplicity | Operationally and structurally simple to implement and manage. |
Structures are complex to build and manage. |
| Flexibility | Solution design can change over time, allowing greater flexibility to test and learn with members. | Less able to evolve to address members’ changing needs. |
Member experience:
| Key considerations | Group annuity | Pooled Income Streams |
|---|---|---|
| Access to capital | The investment can be withdrawn based on a capital access schedule until life expectancy. | This solution could potentially offer an ability to withdraw after a limited period. |
| Low fees | There are no management fees payable on Challenger’s Group Annuity solution. | Members are usually liable for fees. |
| Investment and longevity risk | Insurer bears both investment and longevity risk. |
Member bears investment and longevity risk. |
| Flexibility to switch | Members can change the income linkage of their annuity e.g. from balanced to cash. | This is possible but requires the fund to build multiple sub-GSA portfolios. |
| Death Benefit | 100% death benefit for half of life expectancy, declining to the maximum voluntary withdrawal value which is a linear interpolation between the purchase price and zero of the life expectancy of the life insured. |
Typically offers a death benefit less the income paid to member. |
| Longevity guarantee | Group Annuity (lifetime) solutions are longevity guaranteed. | Pooled income streams are not longevity guaranteed. |
| Market exposure | Market linked annuities allow for income to be linked to a chosen market exposure. | Income is based on asset pool performance and the aggregate mortality experience of group members. |
| Alpha | Challenger's Group Annuity solutions contain embedded alpha and are guaranteed for life. |
Pooled income streams can be managed in accordance with an active investment strategy but cannot guarantee fixed alpha for a member’s lifetime. |
A Group annuity solution: structure and features
A Group Annuity can offer super funds an institutional solution specifically designed to support their guaranteed lifetime income stream offer to members. The Group Annuity is implemented via Master Insurance Policy, issued to the super fund by the insurance partner. The super fund retains their direct relationship with members as well as recognition of funds under management as the fund owns the master policy as an asset.
Cost-effective and flexible
As a zero-fee solution the Challenger Group Annuity offers super funds a fast and cost-effective option for this part of a retirement income product. Unlike a GSA, this approach minimises the need to build internal infrastructure to manage the strategy as this is taken care of within the master annuity policy.
The solution offers several innovative features, allowing super funds to ‘test and learn’. By introducing features including death benefit, voluntary withdrawal, market-linked payments and or fixed rate income and member level switching over time, funds can change their solution design to adapt to the needs of members going forward. Compared with changes to a GSA, operationally this is a relatively simple exercise, similar to changing a term sheet.
Death benefit and withdrawal features of a flexible lifetime annuity:
100% Death Benefit is provided for half of life expectancy and voluntary withdrawal based on a declining capital schedule until death. Surrender value illustrated is the maximum surrender value and is interest rate sensitive.
In this two-part series we have set out what we believe would balance the need for flexibility and certainty for super members’ retirement income over the three phases of decumulation. While there is never one right solution for everyone, we do believe it is possible super funds to create a relatively simple, best-fit solution that supports a seamless retirement income experience for members. The glidepath we have outlined can act as a powerful mechanism to help improve outcomes for members and put them in a better position to maximise both certainty and income over the course of their retirement.
