Volatility in Superannuation Volatility in Superannuation Investments Investments

and and the Australian Age Pensionthe Australian Age Pension

Clare BellisClare BellisDepartment of Actuarial Studies, Department of Actuarial Studies,

Macquarie UniversityMacquarie Universitycbellis@efs.mq.edu.aucbellis@efs.mq.edu.au

How may changes in superannuation How may changes in superannuation investment strategies affect the investment strategies affect the proportions of retired Australians who proportions of retired Australians who receive a part or full age pension? receive a part or full age pension?

Before: most members in one strategy

Now: choice of strategy, eg “cash” or “growth

Future: member choice of fund

→ specialised investment vehicles→ very low level of diversification possible,

→ increased variation across members

The interaction with the Age The interaction with the Age PensionPension

Does the means test give members a put Does the means test give members a put option on their superannuation assets: option on their superannuation assets:

keep the upside, but collect the age keep the upside, but collect the age pension if the downside occurs?pension if the downside occurs?

It depends on post-retirement income.It depends on post-retirement income.

2 extremes:2 extremes:

People on full age pension, can only lose People on full age pension, can only lose pension if their investments soar pension if their investments soar

→→ the state should encourage low income earners the state should encourage low income earners to gamble with their super. to gamble with their super.

People on no age pension, can’t lose pension People on no age pension, can’t lose pension but can get it if their investments flop but can get it if their investments flop

→→ the state should discourage wealthy from the state should discourage wealthy from gambling with their super. gambling with their super.

Projection modelProjection modelAssume:Assume:

30 year-old single male 30 year-old single male 35 years of unbroken employment35 years of unbroken employment SGC 9%, taxed at 15%SGC 9%, taxed at 15% Salary: $50,000 or $100,000 in 2005 Salary: $50,000 or $100,000 in 2005

dollars.dollars. Ignore insurance and administration costs.Ignore insurance and administration costs. Converted into a single life CPI-indexed Converted into a single life CPI-indexed

pension at 65 at $17.40 per $1 papension at 65 at $17.40 per $1 pa

Projection modelProjection modelAssume:Assume:

Age pension $12,535 pa less 40% of Age pension $12,535 pa less 40% of income between $3,172 and $34,508. income between $3,172 and $34,508.

No change in the social security No change in the social security legislation!legislation!

Salary, age pension and the means test Salary, age pension and the means test limits increase by 4% pa. limits increase by 4% pa.

Investment returns are independent log Investment returns are independent log normalnormal

Base case (“balanced”):Base case (“balanced”):

6.5% mean 6.5% mean 7% standard deviation7% standard deviation

for net investment return. for net investment return.

Base CaseBase CaseResults for a salary of $50,000Results for a salary of $50,000

90 percentile range90 percentile range without age pension: 16% to 36% of final without age pension: 16% to 36% of final

salary.salary.including age pension: 37% to 49% of including age pension: 37% to 49% of

final salaryfinal salary

All members receive a part age pension, All members receive a part age pension, averaging 71% of the full pension. averaging 71% of the full pension.

Split members into “defensive” Split members into “defensive” and “growth” fundsand “growth” funds

Suppose Suppose balanced portfolio = 50% “defensive” + 50% well balanced portfolio = 50% “defensive” + 50% well

diversified “growth” assetsdiversified “growth” assets net investment returns:net investment returns:““defensive” =defensive” = 5% mean/ 1% st dev 5% mean/ 1% st devwell diversified “growth” =well diversified “growth” = 8% / 13.8% 8% / 13.8%

Members divide into defensive or growth Members divide into defensive or growth investors.investors.

Results for a salary of $50,000, Results for a salary of $50,000, defensive investorsdefensive investors

90 percentile range, including age 90 percentile range, including age pension: 38% to 39% of final salary pension: 38% to 39% of final salary

→ → Very little uncertainty, but gave up 10% Very little uncertainty, but gave up 10% upside to reduce downside by 1%upside to reduce downside by 1%

All members receive a part age pension,All members receive a part age pension, averaging 81% of full pension averaging 81% of full pension (up from 71% for base case).(up from 71% for base case).

Results for a salary of $50,000, Results for a salary of $50,000, growth investorsgrowth investors

90 percentile range, including age 90 percentile range, including age pension: 35% to 68% of final salarypension: 35% to 68% of final salary

96% of members receive a part age 96% of members receive a part age pension,pension, (and 4% get none), averaging (and 4% get none), averaging 60% of full pension 60% of full pension

(down from 71% for base case)(down from 71% for base case)

Result of dividing the investorsResult of dividing the investorson salary of $50,000on salary of $50,000

State now pays out 2 different rates to 2 State now pays out 2 different rates to 2 groupsgroups

Combined ave. pension = 71%, as before Combined ave. pension = 71%, as before (defensive investors get more, growth (defensive investors get more, growth investors get less, on average)investors get less, on average)

Base CaseBase CaseResults for a salary of $100,000Results for a salary of $100,000

90 percentile range including 90 percentile range including

age pension: 23% to 36% of final salaryage pension: 23% to 36% of final salary

94% of members receive a part age 94% of members receive a part age pension, averaging 34% of the full pension, averaging 34% of the full pension. pension.

Results for a salary of $100,000, Results for a salary of $100,000, defensive investorsdefensive investors

90 percentile range, including age 90 percentile range, including age pension: 17% to 19% of final salary pension: 17% to 19% of final salary

All members receive a part age pension,All members receive a part age pension,

averaging 51% of full pension averaging 51% of full pension

(up from 34%). (up from 34%).

Results for a salary of $100,000, Results for a salary of $100,000, growth investorsgrowth investors

90 percentile range, including age 90 percentile range, including age pension: 22% to 66% of final salarypension: 22% to 66% of final salary

65% of members receive a part age 65% of members receive a part age pension, averaging 25% of the full pension pension, averaging 25% of the full pension (down from 34%). (down from 34%).

Result of dividing the investorsResult of dividing the investorson salary of $100,000on salary of $100,000

State now pays out combined ave. State now pays out combined ave. pension = 38%, up 4% pension = 38%, up 4%

(extra cost for defensive investors not (extra cost for defensive investors not fully offset by savings on growth fully offset by savings on growth investors)investors)

Results of choosing a less Results of choosing a less diversified diversified growthgrowth portfolio portfolio

Assume 8% mean (as before) but 20% s.d.Assume 8% mean (as before) but 20% s.d.

Compared to diversified growth, members Compared to diversified growth, members gain about 16% upside for 3% extra gain about 16% upside for 3% extra downside (means test does not affect upside, downside (means test does not affect upside, dampens downside by 40%) – attractive! dampens downside by 40%) – attractive!

Results of choosing a less Results of choosing a less diversified growth portfoliodiversified growth portfolio

average age pension average age pension for $50,000, = 63% (up 3% on diversified for $50,000, = 63% (up 3% on diversified

growth) growth)

→ → 72% combined average (up 1% on base)72% combined average (up 1% on base)

for $100,000, = 35% (up 10% on diversified for $100,000, = 35% (up 10% on diversified growth, growth, up1% on baseup1% on base ) )

→ → 43% combined average (up 9% on base)43% combined average (up 9% on base)

Results of choosing a poorly Results of choosing a poorly performing high risk portfolioperforming high risk portfolio

Assume 5% mean, Assume 5% mean,

20% st dev (as before).20% st dev (as before).

Not attractive, but quite possible!!Not attractive, but quite possible!!

Results of choosing a poorly Results of choosing a poorly performing high risk portfolioperforming high risk portfolio

average age pension average age pension for $50,000, = 81% (up 21% on diversified for $50,000, = 81% (up 21% on diversified

growth, growth, up 10% on baseup 10% on base) ) → → 81% combined average (up 10% on 81% combined average (up 10% on

base)base)

for $100,000, = 57% (up 32% on for $100,000, = 57% (up 32% on diversified growth, diversified growth, up 23% on baseup 23% on base) )

→ → 54% combined average (up 20% on 54% combined average (up 20% on base)base)

Summary of Age pension %Summary of Age pension %

50,000 50,000 salarysalary

100,000 100,000 salarysalary

Base (balanced)Base (balanced) 7171 3434

Half defensive, half growthHalf defensive, half growth 7171 3838

Half defensive, half less-Half defensive, half less-diversified growthdiversified growth

7272 4343

Half defensive, half poor Half defensive, half poor performing growthperforming growth

8181 5454

All poor performing growthAll poor performing growth 8181 5757

All defensiveAll defensive 8181 5151

ConclusionConclusion

The means test on the age pension does The means test on the age pension does create a put option (on our assumptions).create a put option (on our assumptions).

Cost to the state increases as choices Cost to the state increases as choices become less efficient OR overly defensive.become less efficient OR overly defensive.

Areas for further thoughtAreas for further thought

Allow for tax - could help the state’s Allow for tax - could help the state’s position, though tax payable would be low. position, though tax payable would be low.

Try a more sophisticated economic model.Try a more sophisticated economic model.

Consider allocated pension instead of Consider allocated pension instead of lifetime annuity (which cuts off volatility at lifetime annuity (which cuts off volatility at age 65).age 65).