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Unlike previous generations who worked, paid off a home then retired on the Age Pension, most of today’s retirees draw at least part of their income from a superannuation pension.
That’s made retirement more comfortable for many older Australians, but the rewards come with new risks. Most retirees have their money in pension products where they carry full responsibility for market risk.
With 25 to 30 years of retirement to look forward to, it’s to be expected that there will be a bear market or three along the way. But it’s the timing of big market falls that could determine whether you end your days in luxury or just skimping by.
The twin risks of pension planning
If you’re hoping to retire in the next few years, it’s important to plan how you will manage the interplay of sequencing risk and longevity risk.
These risks can’t be eradicated, but they can be managed with some advance planning.
Investment strategies in retirement
Most Australians have their retirement savings in their super fund’s default Balanced option, which might have anything from 40–70% in growth assets such as shares and property, with the remainder in more conservative cash and fixed interest.
Even in retirement, most Australians remain invested in a Balanced super pension account. Some funds might dial down risk slightly in their default pension product, or members can always choose a slightly lower risk option themselves.
Intuitively, a more cautious approach makes sense as we convert our retirement savings into retirement income, with no idea how long our money needs to last.
This cautious approach is the thinking behind lifecycle super funds that automatically and progressively reduce your exposure to growth assets as you age.
A downhill glide path
A typical Australian in a lifecycle investment option might start their working life with 90% exposure to growth assets. Their investment risk would then gradually glide down to around 50% growth assets before retirement. (Fewer funds also use a lifecycle approach for their default pension products.)
The result is a lifetime glide path that looks like a downhill slope.
While such an approach will help to preserve your capital in the event of a big market fall in the ‘risk zone’ in the years surrounding your retirement, it leaves you exposed to longevity risk.
Balancing the risks
Given that up to 60% of your retirement income could come from investment earnings during retirement, it makes sense to maintain a meaningful exposure to growth assets in pension phase to ensure your money lasts the distance.
Susan Thorp, Professor of Finance at the University of Sydney Business School, points to Australian research that suggests a lifetime asset allocation glide path should look like a V, not a continuous downhill slope.
Research by Geoffrey Kingston and others at Macquarie University Department of Economics found that the share of growth assets should fall by something like 20–50 percentage points over the working life, then another 5–10 percentage points on the day of retirement.
Then, contrary to common practice, they argue that the share of growth assets should subsequently rise through retirement by something like 20–30 percentage points.
To spend the kids’ inheritance or not?
Professor Thorp says the discussion around best practice in retirement asset allocation depends on uniquely Australian factors such as our regulatory system (including minimum pension drawdowns) and the way our Age Pension interacts with super pensions and private savings.
“There would be a lot of people at the moment who think 50% growth assets was relatively high-risk exposure. But in Australia, even with self-funded retirees, the Age Pension is always in the background as a potential safety net,” she says.
She says an individual’s willingness to increase exposure to growth assets in retirement will also depend on the size of the bequest they want to leave their beneficiaries.
If you have in mind a bequest that is fixed in size, you will need to take a more cautious approach to your investments to preserve capital. But if you regard a bequest as a luxury then you can afford a risker investment option, effectively passing on the risk of market volatility to your beneficiaries.
Insuring for longevity
David Carruthers, Head of Member Services at Frontier Advisors, says that whereas sequencing risk can be dealt with by asset allocation, longevity risk is better met by having insurance. While super funds have done a lot to incorporate insurance in accumulation phase, he says they are less on top of insurance for members in retirement phase.
With no default insurance in retirement phase, retirees are on their own.
If your main goal is to ensure you have enough income to cover your consumption needs for the remainder of your life, Professor Thorp says there are three sources of longevity insurance open to you.
- Self-insure by putting most of your assets into cash, but only the very wealthy can afford to do that
- Purchase a lifetime annuity or a partial lifetime annuity
- Rely on the government to insure your income through the Age Pension, which is a very valuable form of longevity insurance.
Carruthers says a deferred lifetime annuity that kicks in when you reach a certain age is a good way to insure against the risk of outliving your savings. For example, if you retire at 65 and your super pension is likely to run dry in 20 years, you might take out a deferred annuity to kick in if and when you turn 85.
That was then, but what about now?
Carruthers says that as recently as January 2020, many retirees were celebrating the fact that their pension account had grown in value after another year of stellar returns, even after they had withdrawn pension income. In hindsight, he says the good times may have made us all a bit complacent.
He hopes the market downturn will encourage members to focus more on the certainty and consistency of pension income, rather than their account balance. To do that, they need to think about their income needs and what they plan to do with their money.
He says it’s common for people heading into retirement to withdraw a lump sum from their super to pay off the mortgage or buy a van before starting a super pension. But withdrawing a lump sum in a market downturn could have a detrimental effect on the amount you have left to support a super pension.
Consider getting advice
“If you are preparing for retirement or recently retired it would be a really good time to get advice,” suggests Professor Thorp. Not only are the market settings complex during the unfolding coronavirus pandemic, but the government is trying to adapt too with regulatory changes around early access to super, deeming rates and minimum drawdown rules for pensioners.
It’s also likely that people’s expectations around participation in the workforce are changing. Some people may have been planning to work a little longer, or continue working part-time, but find that these options are less readily available than they were previously.
“It adds to the complexity, so I think people need to think hard about their retirement planning,” she says.
The wages of fear
If you do push ahead with retirement plans, it’s worth remembering that fear and anxiety are a very poor basis for decision-making, especially if they prompt you to cash out of the market.
We saw this during the GFC, when many retirees shifted money out of shares into cash and bonds. Not only did they lock in their losses at or near the bottom of the market, but many were also reluctant to re-enter the market until well into the recovery, losing the opportunity to benefit from the full upswing in prices.
If the GFC is any guide, people’s appetite for risk is likely to be affected for some time, which could have a negative impact on their future investment earnings and pension income.
As well as taking advice and trying not to be completely driven by anxiety, Professor Thorp also makes the case for a wait-and-see approach.
Stop, look and listen
As the government response to the coronavirus continues, Australians are being given the option of making irreversible decisions such as accessing up to $20,000 of their super fund early.
It’s hard enough for people who are still working to get money back into super because of regulations around contribution caps. But it’s even more difficult for retirees to get money back into super.
“If you are about to make an irreversible decision where there’s a lot of market volatility and a lot of information flowing, there’s real value in delaying the decision,” says Professor Thorp.
That’s because more information will come to you while you wait. Whether it’s good news or bad, that information will give you more understanding of what’s going on and help you time decisions better.
Sitting on your hands while the markets are fluctuating wildly is extremely difficult to do, but it’s unlikely you’ll regret it once the dust has settled.
Sequencing risk and longevity risk have the potential to leave a gaping hole in your retirement savings, so planning ahead and staying the course during periods of market volatility are paramount.
It may be counterintuitive, but research suggests we should reduce our exposure to growth assets in the ‘risk zone’ around the time we retire and then increase them again to stretch our savings further. The exceptions are wealthy individuals who can afford to hold large amounts of cash in retirement and those who want to leave a large fixed bequest to their beneficiaries.