The Importance of Projections in Developing Retirement Strategies

Experts are thick on the ground these days, sometimes with free advice that can prove costly later on. And it seems experts are particularly fond of advising retirees and those about to soak up the sun on weekdays about how and when to spend their money.  One strand of free advice at the moment involves recommending that retirees should spend a bit more, or indeed a lot more, to secure a higher pension to take into account impending changes to the asset test.

Understandably, these changes from January 1 next year have many retirees and those close to retiring thinking hard about whether they should change their financial arrangements. To be more specific, after this date the age pension reduces by $78 per year for each $1,000 of non-home assets over certain thresholds.  At first glance, this looks like you’d have to earn over 7.8% on the extra $1,000 or you’d be better off without the extra $1,000 of assets.

The Actuaries Institute cautions that retirees destined to live to a ripe old age should think twice before accepting some of the advice recently aired on this topic. Indeed, this advice ignores the fact that a partial age pension entitlement generally increases throughout retirement as assets reduce.  The SPD Subcommittee have designed a projection model to estimate the income that assets would support during retirement for a number of case studies.

A Case Study

The SPD considered a number of scenarios. They were based on two single females (Anne and Barbara) who own their own homes. Their only asset, other than their home, was a balance in an allocated pension. It was assumed that the allocated pension was the only source of income for both women and that they continued to live in their own homes throughout their retirement.  The modelling also assumed that the required level of income each year (the combination of the age pension and income from the allocated pension) would be equal to the annual expenditure of ASFA’s comfortable lifestyle for a single person indexed to CPI.

In this case study, we examine one of the scenarios considered.

This scenario assumes the two women plan to retire at age 65 on 1 January 2017 with potentially identical superannuation assets of $450,000. To highlight the long-term impact of spending some of the superannuation assets before retirement, we assumed that Anne increases her spending before 1 July 2017 so as to reduce her retirement assets and receive a higher age pension than Barbara, who decides to save her money.  The additional spending was assumed to reduce Anne’s final retirement benefit available on 1 January 2017 to $250,000.

Chart 1 below provides a year-by-year projection of the incomes of these two individuals to age 100.

Chart 1 – Total income if retiring at age 65

Note: all projected values have been discounted to Today’s Dollars at the rate of Wage Inflation.

 Assumptions          Net investment return on allocated pension assets         – 6.5% pa compound

                                Wage inflation                                                                  – 3.5% pa compound

                                Price Inflation                                                                   – 2.5% pa compound

                                Increase in desired income                                              – Price inflation

                                Increase in age pension rate                                           – Wage inflation

                                Increase in age pension asset test thresholds                – Price inflation

The green and purple lines show the total income received in Today’s Dollars. The blue and red lines show the annual amount of age pension received.

It can be seen that the aged pension paid to Anne in the early years is higher because the pension assets she owns do not reduce her age pension.  However, because Anne has less pension assets she exhausts her assets by age 84, after which she must live on the age pension or use her home to generate additional income.

Barbara, however, at age 84 still has pension assets and therefore receives a higher level of income than Anne for the rest of her retirement. Also Barbara’s total income received is equal to or greater than her desired income level throughout retirement. She will also maintain a balance in her allocated pension throughout retirement and can continue without resorting to using her own home to generate additional income.

An examination of the projected asset values is also instructive. Chart 2 below shows the value of their pension fund assets at the end of each year during retirement.

Chart 2 – Asset Values if retiring at age 65

Note: all projected values have been discounted to Today’s Dollars at the rate of Wage Inflation.

Barbara has significantly greater pension fund assets throughout retirement. This provides added flexibility in her spending pattern. It also allows for aged care costs or bequests in later age. The additional assets also provide a buffer if the net investment earnings are less than the 6.5% we have assumed. Importantly, the fact that Anne receives a larger age pension in the early retirement years does not indicate what strategy results in the best long-term outcome.

The example and related discussion above highlight the significant challenges involved in retirement income modelling and strategy choice. Such tasks cannot be properly addressed through conclusions based upon calculations of a retiree’s first year age pension and allocated pension income entitlements.

The interaction of the many pieces of Australia’s retirement income system is complex. It includes assets and income test rules for the pension, minimum superannuation assets withdrawal requirements and the interaction of other factors such as inflation and investment returns.  Any conclusions based on only considering the income generated in the first year after retirement are liable to be incorrect. Only the output of a year-by-year projection can clearly show how these factors interact throughout a person’s retirement.

Retirees must make decisions about spending capital over time. Ideally, these should allow for a sensible assessment of future cash flow. Year-by- year projections throughout retirement are vital to capture the dynamic nature of the age pension rules as asset values change. However, this is just the start. Given each retiree has an unknown lifespan and faces unknown investment returns, people have valid concerns about outliving their capital.  Models like this one can be extended to assess a full distribution of likely outcomes and take into account the retiree’s asset mix and even health status. This allows people to make informed decisions that meet their required levels of certainty. 

A longer article which considers all the scenarios examined by the SPD Subcommittee is also available. If a copy of the longer article is required (or if there are any questions on the material contained in this article) please contact Andrew Boal, Convenor of the Institute’s Superannuation Practice Committee, or David Bell, Chief Executive Officer of the Actuaries Institute.

The Institue’s SPD Subcommittee authored this article.  The members of the Subcommittee are:

Colin Grenfell, Convenor              Glenn Langton

Thomas Sneddon, Secretary       David Orford     

Bill Buttler                                     Richard Starkey

Esther Conway                             Ray Stevens

Ian Fryer                                       Brnic Van Wyk

Jim Hennington                               

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