Spend your decennial age: a rule of thumb for retirement

In Australia, the majority of people retire with lump sum benefits from defined contribution superannuation schemes and elect to take their benefits in the form of Account-Based Pensions (ABPs).  Determining the appropriate drawdown from assets in retirement is a complicated and important problem faced by many older Australians.  That complexity and importance mean that preparation of comprehensive, independent advice covering retirement drawdown is desirable for the majority who do not have the financial literacy to navigate the decisions themselves.  Advice is often expensive and not a feasible option for everyone.

The Rule of Thumb (ROT) working group, which consists of John De Ravin, Estelle Liu, myself, Paul Scully and Shang Wu, presented the paper ‘Spend your decennial age’ at the Actuaries Summit[1] to address this issue in the absence of advice.  The paper addresses the needs of retirees who are entitled to full or part pension, and who usually do not commission comprehensive, independent advice on drawdowns, but rely on other inputs, such as the ABP minimum withdrawal rates covering pension assets.

The purpose of the paper was to develop some ABP drawdown rules and investigate how alternative drawdown rules affect pensioner welfare as determined by using a utility metric, taking into account the lifetime interactions with the Age Pension means tests for different asset balances.  The ROT working group used the legislated ABP minimum drawdown rates as a starting point and explored some previously published drawdown rules. Then, using the results of dynamic programming calculations that produce optimum drawdown rates by age and asset balance, the working group developed three new drawdown rules, including a simple rule of thumb, that yield improved total lifetime utility of consumption for retirees.

Spending decisions in retirement – current Australian environment

When members of a superannuation fund attain a “condition of release”, they are able to withdraw their funds from the superannuation environment or to shift their accumulation account balance into a pension phase.  For the time being, the pension product environment in Australia is considered under-developed.  Currently the great majority of those who convert their accumulation balances to a pension phase, use their balances to purchase an ABP, which is effectively a pension product where the pensioner has control over both asset allocation and the rate at which the pension is “drawn down”, subject only to statutory minimum withdrawal rates specified in the Superannuation Industry (Supervision) (“SIS”) legislation[2].  Those minimum rates are shown in the following Table.

Table 1: Minimum statutory drawdown or ABPs

Recognising the under-developed state of pension products in Australia, the Government has proposed the introduction of the “retirement covenant”, which is effectively a requirement for superannuation funds to develop Comprehensive Income Products for Retirement (or CIPR).

The working group acknowledged that the retirement product environment may change with the introduction of the Retirement Covenant and the development of CIPRs.  However, despite the imminence of CIPRs and their potential impacts, the authors believe that the key question of what percentage to draw from ABPs will remain critical for the near to medium future.  The reasons are:

1. It is not yet clear how quickly or enthusiastically superannuation funds will develop or promote their CIPRs;
2. It is not clear to what extent retirees will adopt CIPRs in preference to ABPs;
3. Even if CIPRs are widely taken up, the current expectation is that typically only 25%[3] of such products will be annuitised.  If that is the case, then 75% of a typical CIPR will still require a decision by the retiree as to how much of their ABP component to draw down.

Drawdown rules

Various drawdown rules have been developed over the years ranging from Bengen’s 4%[4] rule to “spend the income but not the capital” rule often adopted by SMSFs.  Each rule has its own limitations and the biggest challenge from an Australian perspective is that none of these rules allow for the interaction with the age pension entitlements, which forms a significant component of most retirees’ assets in retirement.

The ROT working group developed three rules, namely A, B and C.  The simplest of these is Rule A, which is defined as:

• Baseline drawdown rate % = the first digit of your age;
• Add 2% to the baseline drawdown rate if your account balance is between $250K and $500K (exclusive);
• Subject to the statutory minimum drawdown rule

By way of illustration, the recommended baseline drawdown rate for someone in their 60s would be 6%. If the person has an ABP balance between $250K and $500K, then the recommended drawdown rate would be 8%.

The second rule, Rule B, has been developed for sophisticated retirees and uses a modestly sized two-way lookup table to determine the drawdown rate.  This rule might be used by retirees who are more financially engaged and who are willing to vary their chosen percentage drawdown rate a little more frequently according to their age and asset balance, as per the table below.

Table 2: Sophisticated retiree rule derived from optimal drawdown ratios

Ages are banded quinquennially, but no distinction is made between ages below 75, or after age 95.  The working group derived this rule by grouping and averaging the optimal drawdown ratios based on age and balance.

The third rule, Rule C, has been developed for financial advisors and has been derived directly from the optimal drawdown analysis (represented in Table 3 below).  Here age progresses in single years, rather than being grouped quinquennially or decennially, and assets are grouped in $100K bands.

Table 3: Financial adviser rule derived from optimal drawdown ratios

The authors have chosen to use a utility framework to assess the drawdown rules instead of using other commonly used measures such as the replacement rate, probability of running out of money, shortfall risk and the funded ratio. This is because the utility framework implemented captures the risk averse nature of retirees, in particular their aversion to asset volatility, as well as the risk of outliving retirement savings (longevity risk) while the more commonly used measures fail to incorporate risk preferences.

The Member’s Default Utility Function (MDUF)[5] has been used as the chosen utility framework to assess the drawdown rules as it represents an attempt to quantify a sensible set of preferences for a superannuation fund trustee to assume on behalf of default fund members, on whom the trustees have limited information.

Conclusion

The complexity of individuals’ personal circumstances emphasises the need for financial advice, yet few Australians are willing to pay for such advice.  Excellent techniques for computing optimal spending for individuals are available but these are complex and currently not available to individuals.  It would seem desirable for individuals to have access to tools into which they could input their own financial and personal data.  The ultimate objective would be to enable good advice to be provided at a very modest cost.

Although it is not possible to find drawdown rules that are simple and optimal for everyone, the rules that the working group has developed all provide better retirement outcomes for retirees than drawing down at the statutory minimum rate.  All the rules developed also respond significantly to the age pension means testing parameters, with recommended drawdown rates being materially higher compared to the minimum statutory rate.  There could be several explanations for this phenomenon, for example: (a) that many do not fully grasp the implications of the means tests for current and future consumption; (b) some have a bequest motive; or (c) retirees value factors that are not captured by the consumption utility framework such as maintaining contingency amounts for health costs or aged care, and a preference for flexibility; or (d) the “nudge” effect of the statutory minimum dominates other issues.

Above all, the authors believe that the paper has identified that the most widely used reference, the statutory minimum drawdown rules, is generally too low to yield anything close to optimal utility.  Individuals would be better advised to spend more, especially in the younger years of retirement.  This finding is consistent with previous Australian studies[6].

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