When Reserve Bank of Australia (RBA) governor Philip Lowe effectively ruled out an interest rate rise in the foreseeable future, retirees around Australia were not exactly thrilled. The RBA has already kept official interest rates on hold at 1.5% since August 2016 and this ultra-low rate has made retirement planning very difficult. But few people realise quite how big the problem is — especially for those already in retirement.
Record low global interest rates and low investment returns from the defensive asset classes traditionally favoured by security-conscious retirees — like term deposits and bonds — are having a significant impact. Although there is no ‘correct’ investment mix for retirees, an emphasis on capital preservation and safety often makes the ultra-low interest rate problem worse.
Where does your retirement income come from?
Research first undertaken in the United States nearly 30 years ago found around 90 cents of every one dollar in retirement income comes from the earnings you achieve on your super investments. Even more surprisingly, around 60 cents in every dollar of retirement income comes from the investment earnings you make in retirement.
According to the 10/30/60 Rule, your retirement income usually comes from the following sources:
- 10% from the money you saved during your working years;
- 30% from the investment returns you achieve before you retire; and
- 60% from the investment returns you achieve during your retirement.
Although the percentages vary slightly for each person depending on their personal situation, the 10/30/60 Rule holds true for most retirees after they leave the workforce.2
The practical implication of the 10/30/60 Rule means if you want to achieve your goals in retirement, earning a good investment return on your retirement savings will be just as important, if not more important, as it was during your working life.
Background: The US study was undertaken by world-renowned pension fund expert, D. Don Ezra in June 1989. It was based on research undertaken with defined benefit (DB) pension funds, but has since been replicated with defined contribution (DC) funds, or normal accumulation super funds as they are called in Australia. The 10/30/60 Rule assumes the person joined their super fund at age 25 and contributes $1,000, with this amount rising 4.75% every year after that until retirement. The person begins receiving a retirement income at age 65 and this rises 3% each year until death at age 90, when their account balance is nil. The investment return is assumed to be 7.8% each year. According to Russell Investment Group, which uses the 10/30/60 Rule in creating investment products for US retirees, the pattern of results for this rule remains fairly stable even if most of these assumptions change. However, if the pre-retirement investment return is different, the percentages can change significantly.
For more information on retirement planning, see the special SuperGuide sections Retirement planning for beginners and Planning for retirement, and SuperGuide article Financial freedom: Retirement planning in six steps.
Why do investment returns play such a big role?
Investment returns in retirement work in a similar way to when you make standard payments on your mortgage over the 20-year or 25-year term of your home loan. During the early years your mortgage payments consist mainly of interest, with capital repayments only starting to grow near the end of the loan period. It’s the same in retirement, with your drawdowns in the early stages mostly being your investment returns. Only near the end do you start actually eating into your capital amount.
If your starting capital remains intact, it gives you the potential to earn more investment returns over the full term of your retirement. Good investment returns postpone the point at which you start to draw on the capital you had amassed at retirement.
For information about investment performance and super funds, see the following SuperGuide articles:
- Superannuation Investment Performance Reckoner: Discover annual returns for 5 investment options
- Investment-performance: we’re the best super fund. No we’re the best
- Mirror, mirror… what super fund is the best performing fund of all?
- Super stars! Top 30 super funds over 5 years
- Retirement performers! Top 30 pension funds over 5 years
- Asset classes: Naming the investment winners for the 2017/2018 financial year (and previous years)
- Super funds gain 9.4% for 2017/2018 financial year
- Top 10 performing super funds for 2017/2018 financial year (and previous years)
- Asset classes: Naming the investment winners for the 2017 calendar year (and previous years)
- Super funds return 10.8% for 2017 calendar year
- Top 10 performing super funds for 2017 calendar year (and previous years)
What does this mean for retirees?
Although choosing the right investment option or mix of assets for your super account is important during your working life, the 10/30/60 Rule shows it may be even more important in retirement. You need to keep your nest egg growing throughout your retirement with a carefully considered investment strategy balancing security with good investment returns. For more information on understanding your risk profile, see SuperGuide article Want investments that help you sleep? Understand your risk profile.
If you retire at age 60, you might be in retirement for 25 or 30 years, so that means you can afford to take a longer-term view of your investments and take a little bit more risk for at least part of your retirement savings in the expectation of generating higher returns.
By including some growth assets (broadly shares and property) in your portfolio, you may be able to put off as long as possible the day you need to start using your capital. Depending on your risk tolerance, growth assets usually have a better chance of delivering the higher returns needed to grow your retirement savings, even if you are drawing down on them at the same time
Note: Being too conservative with your investments in retirement may mean your money grows too slowly and you outlive your retirement savings. For more information about life expectancy in retirement, see SuperGuide article Life expectancy: Will you outlive your retirement savings?
Check out these SuperGuide articles to find out more about planning your retirement and the impact of investment returns:
- How much super do you need to retire comfortably?
- Retirement income: Living on more than $60,000 a year
- The super challenge: At what age should I retire?
- Crunching the numbers: a $1 million retirement (7% and 5% returns)
- Investment returns: Does your super fund use a crediting rate or unit pricing?
- Low yields: A $1 million retirement on 3% or 2% returns
- Investment performance: Assess your super fund in 4 steps
- Super pensions: choosing an investment option in retirement
- Financial freedom: Retirement planning in six steps