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Most retirees around Australia are not exactly thrilled with the current low interest rates, but it’s a situation that seems likely to continue for the foreseeable future.
Ultra-low interest rates make retirement planning difficult and low returns from the defensive asset classes traditionally favoured by retirees — like term deposits and bonds — are making the situation even tougher.
So, with more and more retirees being forced to dip into their retirement capital to meet the rising costs of everyday expenses, it’s more important than ever to understand how to protect your retirement income.
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, with only 10 cents coming from your own savings.
More surprisingly, around 60 cents in every dollar of retirement income comes from the investment earnings you make in retirement.
The 10/30/60 Rule
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
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 generally holds true for most retirees after they leave the workforce.
The practical implication of the 10/30/60 Rule is that 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, than 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 a person joins 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 on retirement planning, see the special SuperGuide sections Retirement planning for beginners and Planning for retirement, and SuperGuide article How to plan for your retirement.
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 towards the end of your retirement 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 amount you had amassed when you retired.
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.
As a retiree, you need to keep your nest egg growing throughout your retirement years with a carefully considered investment strategy balancing security, investment risk and good investment returns.
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 with 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 for as long as possible the day you need to start using your capital.
Need to know
Being too conservative with your investments in retirement could mean your money grows too slowly and you outlive your retirement savings. For more about life expectancy in retirement, read SuperGuide article How long you can expect to live, and what it means for your super.
Depending on your tolerance for risk, 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.