A recent paper by Willis Towers Watson, which looked at all the major options facing big super funds in designing pension-phase strategies for their members, including different tax positions, says retired members should have less in total equities, but 5-10 per cent more in Australian equities than members in the accumulation phase.
The paper, ‘Investing for Retirement: Considerations for Superannuation Fund Trustees, notes the likely differences in the requirements of individual retirees, such as SMSF trustees, and members of a big fund. For instance, most big funds do not need investment income to meet pension payments, but individual investors are likely to.
It supports the appropriateness of big funds continuing to adopt a typical return object of CPI plus 3.5 per cent for both accumulation-phase members and retirement phase members. But it recommends the close consideration of the goal on an after-tax and after-fee basis.
Retirement-phase members do not pay tax on earnings, and therefore have a higher risk/return profile than accumulation-phase members. The value of franking credits from Australian equities is a little higher for retirement-phase members too.
In the Willis Towers Watson sample, a non-retired member targeting CPI plus 3.5 per cent would have an expected long-term return of 7.4 per cent, given a standard asset allocation. The retired member would have an expected return of 8.5 per cent, given the same asset allocation.
The probability of meeting the CPI plus 3.5 per cent objective would be 59 per cent for the non-retiree and 66 per cent for the pension phase.
But the paper suggests that funds should implement a lower-volatility investment strategy for a pension option, which will have slightly lower expected returns but more downside protection in a poor year and a higher probably – 69.0 per cent – of meeting the objective.
The researchers say: “The different tax rates applicable to pension options (relative to accumulation options) present an opportunity for trustees to tailor pension option investment strategies to achieve higher returns than accumulation options, with lower risk. “Several additional opportunities to improve the investment strategy and portfolio construction approach of pension options include:
- Investing a slightly higher portion of equities in Australia (relative to the accumulation section) to take advantage of franking credit benefits for pensioners
- Reducing pension option volatility to improve the likelihood of meeting (after tax and fee) return and risk objectives. These include: investing in assets that have a much greater emphasis on downside protection; reducing equity exposure; increasing exposure to lower volatility strategies; and consideration of derivative strategies
- Increasing portfolio diversity to improve risk/return outcomes (which could include either a higher or lower exposure to illiquid assets, depending on the fund’s liquidity profile).
“We also believe it would be ideal for some assets of the accumulation and pension sections to be managed separately to ensure that all matters (such as tax) are appropriately considered for both phases.”