- On July 14, 2017
Comprehensive Income Products for Retirement (CIPRs) were recommended by the Financial System Inquiry as a means of helping retirees to manage their longevity risk and to be able to draw higher pension income each year. Treasury issued a Discussion Paper and most of the key participants in the superannuation industry have responded with submissions. This consultation process will advance understanding across the market, but is unlikely to resolve the debate. There are still too many outstanding issues and uncertainties.
We have reviewed the purpose of CIPRs and then considered how best to develop these products to meet the government’s objectives for them. We also analysed the various types of CIPRs and tested where they might add value to different groups of retirees. As part of this we considered whether the objectives might be met more efficiently through other means for some groups.
There are clear benefits in pooling resources within superannuation. Members participate in investment pools while they accumulate their benefits and in insurance pools for group life cover. Many believe that mortality pools in retirement will also be beneficial. The government regards CIPRs as a mechanism for improving risk management of retirees via pooling of mortality.
We agree that mortality pooling has many advantages but current solutions have the effect of bundling mortality pooling with investments which remove some or all of the equity-risk premium. The equity-risk premium has made an important contribution towards the Australian superannuation system over an extended period and is worth more to members than the value from mortality pooling.
INCOME EFFICIENCY AND BEQUEST
The Discussion Paper provides analysis by the Australian Government Actuary which shows that CIPRs could achieve an uplift in income of 15% – 30% compared to an Account Based Pension (ABP) with minimum pension drawdowns. However, this analysis ignores the value to the member of any residual capital in the ABP, relative to the CIPR and further omits the fact that an ABP invested in a diversified portfolio could be drawn down at a rate higher than the minimum and last to (say) age 100.
The analysis also does not take the Age Pension into account or the interaction of CIPR and ABP products with the Means Tests. This is a shortcoming as members will base their decisions on their total income.
When we take the Age pension and the benefits of a diversified investment portfolio (and its extra returns courtesy of the equity-risk premium) into account there is very little income uplift. The following table showing the present value of annual income illustrates the situation.
The Age Pension acts to increase the attractiveness of the ABP relative to the CIPRs and the potential uplift in income is modest at best.
Potential purchasers of CIPRs will not just be considering income. They will be weighing up the trade-off between income and access to capital for emergency use and for bequests. The trade-off from losing any bequest is shown by calculating the expected present value of all future pension payments vs. expected payments on death.
The table shows that retirement income is increased by using a CIPR but the trade-off is the reduction in the value of benefits on death, and an overall reduction in value.
Treasury has proposed that CIPRs not be part of a default retirement strategy; further, trustees will not be required to offer them as a choice for members. Under this structure, we are not confident that many members will be attracted to CIPRS, and the SMSF segment will not have any coverage. As retirees within SMSFs will likely leave the largest bequests, one of the government’s objectives will not be met.
Whilst some retirees will see benefits from the features of CIPRs for some of their retirement needs, we do not believe that voluntary purchase or opt-out CIPRs will be successful at addressing the systemic issues raised in the paper.
Thus, we are sceptical that CIPRS will be a success on a voluntary basis.
A possible solution might be to move to a modest level of compulsion. The quarantining of a portion of the asset base at retirement to support a defined income at older ages provides the best value for money. A compulsion to set aside an amount of the retirement balance for this purpose might therefore be practical.
Our suggestion is that, say, 15% of the retirement balance must be allocated to a CIPR with limited return on death. This is not appropriate for small balances so it could be limited to balances at retirement between, say, $250,000 and $1,000,000. Members would also be able to allocate more on a voluntary basis (or to opt-out if they were not interested in a CIPR).
We believe that this would have the following benefits:
- It would ensure the growth of a non-selected mortality pool of sufficient size.
- It would allow for a more appropriate long term investment strategy supportive of long term returns.
- It would reduce the flow of assets to voluntary and involuntary bequests.
- The performance of these pools would provide a solid base from which to attract voluntary purchases (although the pricing would still need to reflect the nature of the purchase).
- The combination of a standard ABP with the mortality pooled CIPR would provide the flexibility for access to assets that retirees desire as well as greater flexibility of asset allocation.
To read Rice Warner’s full submission to Treasury please click on the link below.