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Creating a retirement investment portfolio requires a different mindset to the investment strategies you may have used to save for retirement.
During your working life you (hopefully) made regular contributions to your super fund where it remained untouched and compounding for three to four decades.
In retirement, it’s the reverse. Once you transfer your super into retirement phase, you withdraw regular income to live on and can’t contribute any more to grow your balance. Any growth must come from earnings on existing investments.
This drawdown of wealth in retirement can last almost as long as the wealth accumulation phase. Depending on when you retire and how long you live, you could be looking at up to 30 years or so.
Putting the income horse before the investment cart
Before you get into the nitty gritty of how to structure your retirement investment portfolio, you need to get a handle on how much income you will need to live on.
There’s no single answer to this question; everyone’s wants and needs are different. As a starting point, look at your current spending patterns and adjust for work expenses, mortgage payments, voluntary super contributions and other items you hopefully won’t need to budget for in retirement.
Assyat David, founder of Aged Care Steps, suggests taking this process one step further by dividing your living expenses into two types of income:
- Essential income for food, electricity and other necessities
- Discretionary income for holidays, presents and non-essential spending.
This will help you structure your portfolio with the potential to provide different types of income from different types of investments.
Factor in changing income needs
One mistake many people, and their advisers, make is to talk about the retirement years as one homogenous period with reasonably constant income needs throughout.
“A lot of advisers say to index your income requirements to inflation for your life expectancy, but we say the income you need will change based on your health,” says Assyat David.
David says spending over the three stages of retirement is more like a smile curve as people tend to move through three distinct stages of retirement:
- The active years in the first decade or so with no major disabilities. On average, this stage is estimated to last 45–47% of retirement years.
- The quiet years where many people have some level of disability but can care for themselves, perhaps with a little extra outside support. This represents on average 30–36% of retirement years.
- The frailty years when you may need help to live at home and/or move into aged care accommodation. This stage is estimated to last 17–25% on average.
Spending is typically highest in the early active years when travel and social activities outside the home are on most people’s wish list. Spending generally declines in the quiet years when people spend more time at home, before rising again in frail old age due to the high costs associated with declining health and aged care.
Plan for frailty
It may surprise many readers to see how long they might expect their frail years to last – up to 25% of their retirement years on average for someone who retires aged 65. Aged Care Steps developed the estimated duration of each retirement stage above from Australian Institute of Health and Welfare statistics.
It’s not just medical costs that go up as we age; capital expenditure may be needed for home modifications and additional income to fund aged care at home or in an aged care facility.
The government picks up the tab for some aged care services on a means-tested basis. But those who hope for a more comfortable old age will need to plan.
ASFA’s Retirement Standard recognises the special spending requirements associated with the frail years by providing separate budgets for people aged 65 plus and 85 plus.
Different approaches to portfolio construction
Once you have considered your income needs, the next step is to think about how you will structure your portfolio. While all investment involves risk, the risks you face in retirement are different to those in the accumulation phase, namely:
- Longevity risk or the risk that your money will run out before you do
- Sequencing risk or the risk of a major market fall around the time you begin to draw down on your savings. If this happens early in retirement you want to avoid having to sell assets into a falling market to cover living expenses, thereby crystallising your losses and reducing the amount available to support your income needs later in life
- Frailty risk or the risk of inadequately planning for higher health-related costs late in life.
From a portfolio construction perspective, Assyat David suggests two ways to think about providing the income you require through the various stages of retirement:
- An income-layering strategy
- A bucket strategy.
An income-layering strategy
To cover essential spending, you need a set amount of income from secure, guaranteed sources. This might include Age Pension payments, annuity-style products that pay a pre-determined income for life, and cash and term deposits. In other words, take a holistic approach and assess income from all sources, inside and outside super.
Discretionary income may then come from more risky investments such as rental income from investment property and dividends from shares or an account-based super pension. These assets may fluctuate in price due to market movements, but they also provide the potential for capital growth to cover your long-term income needs.
If you have a super pension, you could draw down income from the cash component of your account first and have the balance of your savings in a diversified portfolio. The bigger your super balance, the more you can allocate to growth assets once your income needs are secured.
David says this approach is not ‘set and forget’ but will need constant monitoring and adjustment as your circumstances and spending change in each of the three phases of retirement. For example, as you become less mobile you may cut back on discretionary income for travel and yoga. Then in frail old age you may need to increase access to income for home care.
“This may require adjustments to drawdowns from your income stream products, management of term and lifetime annuities, and consideration of other strategies such as the potential capital drawdown in later years to fund changes to your home if you become less mobile,” says David.
A bucket strategy
A popular portfolio construction method used by many financial advisers is the bucket strategy. There are many variations, but typically it involves allocating funds to three buckets:
- The cash bucket supports two to three years of your retirement income needs with cash investments. This can be held within your super pension account. Then when you withdraw income you only draw down from this cash portfolio. When the bucket is empty you start drawing income from the next bucket.
- The capital stable bucket holds conservative fixed interest investments but still has some exposure to growth.
- The growth bucket contains the rest of your money in a growth-oriented portfolio of shares, property and the like. The aim is not to touch this source of funds for maybe five years or more. If the market falls in the meantime, you avoid the problem of having to sell investments to support your income needs and crystallising your losses.
The idea is to provide long-term capital growth as a means of managing longevity risk, with enough cash and fixed interest investments to provide the retirement income you need in the short to medium term.
In practice, you may hold some investments outside super while keeping the lion’s share inside super for the tax advantages. The key thing is to look at your portfolio as a whole and make sure you have access to enough cash for your income needs.
A fourth bucket
David suggests retirees also consider a fourth bucket to meet future aged care costs. “You could use this to pay for home care or you may need access to capital for home modifications,” she says.
You could invest in a product such as a deferred annuity that starts paying income at a specific age, say 85 or 90, when your super is timed to run out. That way, you don’t have to worry about living to a ripe old age and running out of money.
This is where your family home also comes into play as an integral part of your long-term strategy. For example, you could plan to downsize or release home equity using strategies such as the government’s Home Equity Access Scheme (previously called the Pension Loans Scheme) or a commercial reverse mortgage.
When it comes to constructing a retirement income portfolio, it’s important to start with how much income you think you will need to live on, separating essential needs from discretionary spending. You also need to plan for changes to your spending as you move through different stages of retirement. Then you can think about how you will structure your portfolio, keeping in mind the investment risks that are peculiar to retirement planning.