Retirement Trilemma: Borrowing ideas from beyond financial services
The superannuation industry continues to mature, and more assets are moving into the retirement phase. This presents the superannuation industry with new challenges – and new opportunities. In the accumulation phase, it is relatively simple to satisfy the needs of members; increase their superannuation balance until the point at which they retire. Of course, there is more to it than this. Consideration needs to be given to asset allocation and member risk appetite (among other things) but, for the most part, the problem is generally well understood by members and funds alike.
In retirement, members’ financial objectives are more complex. In addition, members in retirement are much more engaged than those still accumulating. They can no longer leave decisions about spending their assets to a dim distant future. They must make those more complex decisions now.
The Retirement Income Covenant
The framing of the Retirement Income Covenant recognises the complexity facing retirees by requiring superannuation trustees to provide a retirement strategy for their members that helps them to achieve and balance three interlocking and potentially competing objectives:
- Maximise their expected retirement income, inclusive of the Age Pension and any other relevant income support payments;
- Manage any risks (including longevity risks, investment risks and inflation risks) to the sustainability and stability of their expected retirement income; and
- Have flexible access to sufficient funds during retirement.
The Covenant acknowledges that there exist trade-offs between each of the objectives above, which presents superannuation funds and members with a retirement trilemma.
Due to the nature of this trilemma, the design and operation of retirement income solutions are more complex than accumulation products and will require funds to effectively and clearly articulate the trade-offs of each solution to an Australian population with relatively low financial literacy. This is exacerbated by the generally low appetite for members to pay for comprehensive personal advice to assist them. This seems like a gargantuan task and, in many ways, it is. A common solution proposed is scaled advice – that is, providing members with low-cost digital tools and calculators that aim to improve financial literacy around retirement. To date, take-up of such tools in retirement has been low which suggests that the industry’s approaches to framing the problem facing retirees and explaining the potential solutions in the context of this framing is not cutting through. Perhaps we can look to areas outside of financial services to help us solve this problem for the retirement trilemma.
Picking a cocktail is not always an easy decision. You may have heard a bartender ask an indecisive patron “Do you feel like something strong, sweet or sour?”. More often than not, people would like a balance between these preferences. Consider Figure 1 that shows the position of two particular cocktails in relation to these three preferences. If a person feels like a strong and sour cocktail, they will pick the Margarita, but if they are looking for a cocktail that isn’t very strong but sweet, they will pick the Pina Colada. The bartender essentially memorises this triangle and uses it as a ready reckoner to suggest to the patron a cocktail that is consistent with their preferences.
Figure 1: Cocktail triangle
A similar idea can be applied to the retirement trilemma, where each corner represents one of the objectives of the Retirement Income Covenant (see Figure 2). An interactive version of the triangle can be implemented on retirement planning tools where the pointer in the middle moves to appropriately reflect the retiree’s objectives. For example, where a retiree moves the pointer to increase the weightings toward “Maximising income”, this may recommend a higher allocation to growth assets. Where a retiree moves the pointer towards “Managing risks”, this may recommend a higher allocation towards an annuity or a more conservative drawdown strategy of the retiree’s account-based pension. Utility functions may be used to map the coordinates on the triangle to specific compositions of products and drawdown strategies.
Figure 2: The retirement trilemma
One issue with this approach is that there are over 5,000 distinct combinations in such a triangle (assuming 1% increments) and it would be operationally difficult to offer so many retirement solutions to members. Fortunately, we can again look outside of financial services to help us solve this problem. This time, let’s leverage an approach taken by the Victorian Government in relation to education.
In defining school catchment zones, the Victorian Government uses Voronoi polygons[1]. A Voronoi polygon is one whose interior consists of all points in a plane which are closer to a particular lattice point than to any other. For example, Figure 3 shows a subset of school catchment zones in Melbourne.
Figure 3: Victorian school catchment zones (Source: Victorian State Government)
The individual schools are the points which construct a locus for each polygon to optimise school districts across the state.
For retirement planning, each retirement solution, comprising a combination of products with specific settings as to investment mix, draw down rates etc., would form a central point of each polygon. The polygons would then optimise their applicability across the plane of the trilemma triangle. This would allow funds to provide their members with a reasonable number of retirement solutions which can be tailored to meet their needs. Figure 4 shows the triangle for a retirement income strategy with seven retirement solutions and their corresponding regions using a Voronoi diagram.
Figure 4: Retirement strategy triangle with Voronoi diagram
The beauty of this approach is that a fund could construct unique triangles for each of their member cohorts. Each member would have their general traits captured in the cohort triangle and be able to then satisfy their unique preferences relatively easily by finding their position within the triangle. This provides a route to the holy grail of mass-customisation that was sought by Treasury in 2016[1]. Mass-customisation provides product providers with the cost benefits associated with mass-production, while also allowing for tailoring at the individual level. For example, see Figure 5 for how an automated visualisation can be presented to a member who has indicated a strong preference for risk management above all other objectives. As such, the algorithm has selected a conservative drawdown strategy and a combination of account-based pension and guaranteed deferred lifetime annuity.
Figure 5: A tailored solution for a member
Balancing retirement objectives is not a trivial task and communicating the trade-offs involved in the retirement trilemma is even more challenging for trustees, who must do this for a largely unadvised member base. By borrowing ideas from outside of financial services, trustees can balance member objectives whilst simultaneously abstracting away the detail to keep the messaging simple. This will help trustees to retain and attract members, improve retirement outcomes and reduce the costs associated with the provision of retirement guidance and advice.
For a live example of digital tools assisting with the cocktail trilemma, be sure to check out our fun interactive site: Retire Mix.
Footnotes
[1] https://mathworld.wolfram.com/VoronoiDiagram.html
[2] https://consult.treasury.gov.au/retirement-income-policy-division/comprehensive-income-products-for-retirement/
