Income targeting in a Retirement Portfolio

Given the Retirement Income Panel’s work over the past year, super funds need no more motivation to answer the critical question: how can funds deliver an adequate pension to retired fund members? The question, however, can’t be answered without determining what an ‘adequate’ pension is. This ResearchBite considers how a hypothetical fund creating an income-targeted Australian equity strategy for its ‘CIPR’1 (or choice) retirement solution could benchmark the yield outcomes of this portfolio in a way that helps answer this question.

Retirement solutions are a new frontier for most funds; not shackled by legacy products, and not the focus of peer surveys or the APRA heatmap. It is a rich ‘greenfield’-type opportunity to get back to the specific needs and sensitivities of fund members and embrace problems not yet solved by the industry – truly, a licence to innovate.

Let’s begin by suggesting a fairly obvious way of measuring and benchmarking yield on a portfolio which has tracking error defined in relation to the S&P/ASX 200 in a performance period:

This sets up a straightforward argument for the fund: the portfolio delivers an ‘adequate’ pension as long as portfolio yield equals or exceeds the yield of the S&P/ASX 200 over the performance period. Longer time periods such as rolling 3 or 12 months can be easily added. However, we can immediately see an opportunity to get closer to the actual retired member experience by adding franking credits to this calculation:

This is an important step forward: franking credits provide significant value to retirees, as is well known.3 In previous research, 4 we estimated that franking credits on the S&P/ASX 200 were worth 1.5% annually to retirees and an active, franked dividend targeting strategy could add as much as 2% in total returns annually to retired fund members (admittedly, with risk implications). A pension-focused Australian equity strategy without franking visibility and ‘smarts’ misses an important portfolio lever to meet its income targets. It also denies the super fund the opportunity to answer credibly whether the yield produced delivers an adequate pension for retired members.

This market-cap benchmark approach to yield will appeal to many funds: it’s relatively simple to implement, reflects familiar performance and benchmark concepts and showcases how a super fund’s thoughtful portfolio design can beat a ‘dumb beta’ equity portfolio yield outcome. Yet, query whether it reflects how the fund views investment success, rather than how a member would view pension success. A way to close this agency-principal gap is to consider the member’s appropriate ‘counterfactual’ – where the (principal) member would have otherwise invested their retirement savings but for the scale and expertise of the (agent) super fund. Let’s say existing member data, a pre-retirement member survey or information gleaned from financial advice provided to members allows the fund to identify member cohorts who would otherwise invest their retirement savings in term deposits (cohort A), 5 ‘blue chip’ Australian companies (cohort B) or a rental property (cohort C). This could justify measuring retirement portfolio yield success as follows:

A different way, again, to answer whether a pension delivered is ‘adequate’ could get closer still to the heart of what ‘success’ means to a retired super fund member. Below, benchmark A best captures the government’s proposed legislated objective of super to “substitute or supplement the age pension in retirement”; benchmark B is the most personal, aiming at a yield level that provides a sufficient salary-replacement for the retired member; while benchmark C is perhaps the most aspirational, based on the published ASFA ‘comfortable living standard’ dollar figure.5

Disclaimer:

This information is for use with wholesale and qualified investors only and may not be distributed to the public.

Footnotes:

1 A comprehensive income product for retirement (CIPR) is a retirement solution that provides a retiree with income, flexibility and protection against investment and longevity risk. While for simplicity our analysis focuses on a 100% equity portfolio, we note that equities in a live CIPR solution will form part of a balanced portfolio. 2 We ignore important performance methodology details like timeweighted versus cash-weighted returns not relevant to explaining our yield ideas. Calculations would, obviously, be period-specific.

3 The Australian Labor party’s proposal to limit franking credit refunds before the 2019 federal election was vastly unpopular amongst retired super fund members who rely on franking credits as a source of yield. Many commentators believe that the preelection lobbying that took place to protect retiree’s franking credits helped deny the Labor party its expected election victory. 4 Raewyn Williams, Martha Strebinger, Vassilii Nemtchinov and Travis Bohon, ‘A Fresh Look at Franking’, Parametric, January 2017, https://www. parametricportfolio.com.au/ insights-and-research/a-freshlookat-franking. 5 See https://www.superannuation. asn.au/resources/retirementstandard. Practical adoption of this benchmark requires decisions around whether to use basic or comfortable, and single or couple, living standards. 6 Source: KPMG Super Insights Report 2020, https://assets.kpmg/ content/dam/kpmg/au/pdf/2020/ super-insights-report-2020.pdf

Raewyn Williams and Josh McKenzie