Retirement income covenants (and egg metaphors)

By Stephanie Malon
APRA Financial Services

'Hatching' the retirement nest egg 10 min read

The long-promised retirement income covenants are slated to come into effect on 1 July 2022. The proposed covenants are aimed at improving retirement outcomes, including by moving retirees away from a 'nest egg' mentality towards spending more in retirement – or 'hatching' the nest egg (to borrow the extended metaphor of APRA's Deputy Chair).

We take a look at the exposure draft legislation and what it all means for trustees.

Why do we need the covenants?

To understand the proposed covenants, it is helpful to revisit their genesis. As many of you will remember, the Government flagged the introduction of a retirement income covenant in the 2018/2019 Federal Budget, declaring that trustees have 'no obligations…to consider the retirement income needs of their members'. After a series of delays (see here), exposure draft legislation and explanatory materials were released in late 2021. The draft explanatory materials continue to run a similar line – that  there's a gap in obligations of trustees as they relate to the retirement phase.

To take a step back, the underlying concern is that retirees are not currently supported to effectively manage the decisions and trade-offs that come with retirement. There appears to be a particular worry – most recently articulated in a Treasury position paper – that people are inadvertently trapped in a 'nest egg' mentality to preserve their pot of gold in super until they die, rather than drawing down on it to give them a better quality of life in retirement.

There is an open question as to whether or not a gap in trustees' obligations is the cause of these concerns (think of the best financial interests, sole purpose, member outcome, design and distribution to name a few of the existing obligations that just might be relevant) – or whether other issues, such as barriers to financial advice, might be the culprits. However, that is a topic for another day – it appears we are on a steady march to five new covenants come 1 July 2022, bringing us to a grand total of 34 covenants (in case anyone is counting).

What do the covenants require?

The first proposed retirement income covenant (the 'core covenant') requires trustees to formulate, review regularly and give effect to a strategy that addresses how they will assist beneficiaries who are 'retired or approaching retirement' to achieve and balance three objectives:

  • to maximise expected retirement income over the 'period of retirement';
  • to manage expected risks to the sustainability of 'retirement income' of the 'period of retirement' (being longevity, investment inflation and any other risks to the sustainability and stability of 'retirement income'); and
  • to have flexible access to expected funds over the 'period of retirement'.

The meaning of the terms 'period of retirement' and 'retirement income' for the purposes of this covenant are to be determined by the trustee – but, at a minimum, 'retirement income' must include income from super and the Age Pension. The trustee must also determine the class of beneficiaries who are 'retired or approaching retirement', and may divide the class of beneficiaries into sub-classes.

This core covenant is supported by four other proposed covenants, being:

  • to take reasonable steps to gather the information necessary to inform the strategy;
  • to record the strategy in writing;
  • to record in the same document a range of matters – broadly, determinations made for the purposes of the strategy, other decisions in respect of the strategy the trustee considers significant, the steps taken to gather relevant information and reasons for all of those things; and
  • to make a summary of the strategy publicly available on the website.

As you'll have noticed, many components of the covenants will require the exercise of considerable judgement by trustees. And trustees are understandably nervous about what exactly they need to do to satisfy the covenants. APRA has said it is thinking carefully about what guidance might be needed, but emphasised that it does not intend to issue extensive guidance in the short term, and reminded trustees that it will not seek to clarify the intent of the law. So, in the absence of further clarity in the final legislation and explanatory memorandum, trustees will need to make their own calls.

What does this mean in practice for trustees?

In a nutshell, the key output for trustees will be a strategic document that identifies the retirement income needs of the members and presents a plan to service those needs, accompanied by information gathering, record keeping, disclosure and review requirements.

To break this down, trustees would be looking at the following key areas:

Information gathering

The proposed requirement is 'to take reasonable steps to gather the information necessary to inform the formulation and review of the strategy'. The draft explanatory materials start off by suggesting that this inquiry might be able to be relatively confined – ie it should only involve gathering information to the extent needed to form a 'broad understanding of beneficiaries to identify the types of assistance that could be offered'. However, the materials go on to list a range of specific information that may be relevant to the covenant which won't necessarily be readily known by a trustee, eg expected eligibility for the Age Pension, whether the beneficiary is partnered or single, home ownership and mortgage status, expected retirement age and so on. It suggests that this sort of information can be sourced from beneficiary surveys, research reports by peak bodies and academic literature and publicly available data, eg from the ABS, the government actuary, the ATO, APRA, Department of Social Services and HILDA surveys. Piecing together the government data will be challenge enough in itself, but collecting accurate and representative data from surveys may be difficult as it is reliant on beneficiaries volunteering their personal details to trustees and involves cost and effort. Ultimately, we suspect trustees will look at carefully balancing the benefit to members against the cost of gathering information when considering whether they have satisfied the obligation to take 'reasonable steps'.

Determine who is 'retired or approaching retirement' and any sub-classes

Trustees must determine the class of beneficiaries that they consider meet the description of 'retired or approaching retirement', and draft explanatory materials emphasise that a trustee can approach this determination in any way the trustee considers appropriate. Trustees will therefore need to give some thought as to the class of beneficiaries who they consider fall within this category – though the draft explanatory materials suggest that fairly obvious factors are likely to be relevant to the determination, such as age, gender, employment status and when the trustee expects beneficiaries to satisfy a condition of release requirement or retire.

Perhaps a more difficult question is what (if any) sub-classes the trustee should designate for beneficiaries who are 'retired or approaching retirement'. The draft explanatory materials suggest that developing sub-classes will allow trustees to formulate strategies more tailored to sub-classes – with an example that, if a trustee is aware that a sub-class of beneficiaries would likely hold a mortgage at retirement, that information can be used to inform the assistance they provide to those members (which appears to assume trustees can obtain that information – see above). While the exposure draft legislation does not include a positive requirement for trustees to designate sub-classes, trustees may be nervous that they're not meeting other covenants or broader obligations if they do not do so, particularly where there are obvious distinctions between sub-classes. We can expect trustees to be thinking about this aspect carefully.

Determine 'retirement income'

Trustees will also be required to determine what constitutes 'retirement income' for the purposes of the covenant. At a minimum, this includes income paid from, or supported by, any superannuation interest from the fund, and income from the Age Pension. However trustees may include income from any other source if the trustee determines it is appropriate. The draft explanatory materials suggest that other income that may be appropriate to include can be income from non-super assets, income from a partner, other income support or super interests held outside the fund if the trustee considers it to be suitable. Whether or not including such amounts is 'appropriate' is another (potentially difficult) question left to the determination of trustees.

Determine 'period of retirement'

Trustees will also be required to determine what constitutes 'period of retirement'. The draft explanatory materials say that a trustee may wish to consider retirement patterns of their members when working out the start of the period, and distribution of life expectancies of their members in forming views about the end of the period – and this period may differ for different sub-classes.

Formulate, review and implement 'strategy'

As mentioned, the core obligation as described is to formulate, review regularly and give effect to a strategy to 'assist' the relevant class of members to meet the objectives prescribed. The draft explanatory materials specifically say the trustee has discretion to determine the type and scope of assistance provided – so in theory this could be one or more of a combination of advice, nudges or compulsion. This is backed up by some of the examples given in the draft explanatory memorandum:

  • developing or offering specific retirement income products;
  • drawdown patterns that provide higher incomes;
  • factual information about key retirement topics, such as eligibility for the Age Pension and the concept of drawing down capital as a form of income; and
  • providing guidance to beneficiaries about potential income in retirement through calculators, and expenditure calculators to identify income and capital needs over time.

APRA has suggested that trustees are likely to be considering how their product governance could be invigorated and whether the business performance review conducted as part of SPS 515 has revealed opportunities for improved retirement outcomes.

In all, there are likely to be some easy wins in a retirement income strategy, but others might require a lot more thought and effort. And there are two obvious matters that fall into that latter category:

  • Innovative retirement products: APRA has emphasised that trustees need the boldness to innovate on retirement income products, given that there are relatively few products available – but they should not take unnecessary risks. APRA has stated it is closely collaborating with ASIC, Treasury and the ATO on the product innovation and sandboxes and regulatory approvals and that they expect to see innovation on well-thought-through, risk-aware products. Whether this will help overcome previous challenges encountered in retirement product innovation (including on the demand side) is one of the biggest questions around this reform.
  • Financial product advice: The explanatory draft materials are at pains to point out that trustees are not expected to give effect to a strategy by providing personal advice. However, it is not difficult to see how this boundary could be crossed in attempting to implement the covenant given the breadth of that definition (eg in the context of providing recommendations or encouragement for a cohort with particular characteristics to make drawdowns greater than minimum levels). It has been suggested that a carve-out for personal financial advice (akin to that provided for design and distribution obligations) ought to be provided – unless and until that happens, trustees will likely tread very carefully in implementing the covenant.
Documenting and publishing

Last but not least, trustees will be required to document the strategy, and a range of related matters, and make a summary publicly available.

What's next?

Consultation on the exposure draft legislation has closed and we are awaiting the introduction of a bill to Parliament and the passage of legislation. However, there is very little time (a little over six months) until the proposed commencement of the legislation. It seems that – as with many recent reforms – trustees will likely have little choice but to start preparing (and incurring costs) before knowing the final form of legislation. It would be good for everyone's nest egg (whether hatched or not) for trustees to be given as much advance notice as possible of the final form of the covenants before they become law.