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These are challenging times for investors, especially if you’re about to retire or already drawing on your super.
After 10 years of positive returns from super and 28 years without a recession in Australia, the risk of a market correction or a more prolonged downturn are building.
Geopolitical and economic risks are rising
The ongoing trade war between the US and China, the fallout of a possible no deal Brexit in Europe, rising tensions in the Middle East and signs of a slowing global economy are creating uncertainty for investors, central banks and policy makers alike.
In Australia, a slowing economy and weak wages growth have forced the Reserve Bank’s hand. To stimulate economic activity, it has lowered official interest rates and further cuts are expected to take us close to 0%.
While the RBA is focused on steadying the ship, low interest rates have taken the wind out of the sails of retirees and anyone who relies on income from bank deposits. With bonds and shares both looking close to fully valued after a long bull run, investors face a quandary.
The lessons of history
No-one can predict when markets will turn, although history teaches us that markets are cyclical and periodic downturns can be expected. When this happens, the impact can be magnified for super fund members moving into retirement phase.
“For members shifting their super savings to a pension product, a number of down months in relatively quick succession will mean they draw down on a smaller pool of savings than they might have anticipated,” says SuperRatings executive director, Kirby Rappell.
As the chart from SuperRatings below shows, the market stumble at the end of 2018 dragged down pension balances. The median balanced option fell further than the lower risk capital stable option, before rebounding. Both options finished the year to August up 6.2%, although members in the capital stable option probably slept a little more soundly along the way.
Pension balance over 12 months to end August 2019*
Source: SuperRatings
*Assumes a starting balance of $250,000 at the end of August 2018 and annual 5% drawdown applied monthly.
But what would have happened to someone who retired in December 2018?
Looking to the chart again, and comparing members with a balance of $250,000 in August 2018, a member in the balanced option retiring in December would have been $8,500 worse off than someone in the capital stable option.
This simple illustration highlights three concerns for members close to or in retirement:
- Timing, also referred to as sequencing risk. To learn more see SuperGuide article 5 ways sequencing risk affects your retirement.
- Choosing the right investment mix for your risk tolerance and stage of life.
- Having access to cash for living expenses if the market tanks.
Choose the right investment mix
Experience shows us that investors often react to a falling market by switching out of shares into cash at the bottom of the market. Not only do you risk crystallising your losses, but you also miss out on the upswing that inevitably follows.
During the GFC, may retirees sold shares and moved to cash. At the time, term deposit rates were around 7-8% and came with a government guarantee, while the dividend yield on shares was around 4%.
Fast forward 10 years and dividend yields are still around 4% but term deposit rates are less than half that and falling. In the long run, many investors would have been better staying the course. According to SuperRatings, the median balanced pension fund has returned 8.8% a year over the last 10 years and 10.2% over 7 years.
Know your risk tolerance
Financial adviser Russell Lees, founder of independent advisory firm Kauri Wealth and vice president of the Australian Investors Association says investors should ensure their portfolio is aligned with their risk profile.
This is always the case but doubly so for anyone who is invested for the best of times and would find the worst of times difficult to tolerate.
“Be aware of your risk tolerance and check that your asset allocation is appropriate, so you are not exposed to emotional decisions at the wrong time. Choose good quality investments, with heaps of diversification and be prepared to make changes to your asset allocation when needed,” he says.
Be prepared to adapt
While constant tinkering with investments is not recommended, that doesn’t mean you shouldn’t adapt to changes in market risks or your retirement.
Lees says he has recently increased the defensive component of client portfolios from a typical balanced asset allocation of 30% defensive/70% growth assets to 40% defensive/60% growth. Within the defensive portfolio
He has also made changes within portfolios. He has increased cash allocations from a typical 4-5% to 6-7% and reduced reliance on bank hybrids in favour of corporate and government bonds to diversify exposures and become less reliant on the banking sector.
Assess your liquidity needs
For retirees, another lesson from the GFC was the importance of having enough cash to cover living expenses during a prolonged market downturn. Failure to do so may mean you have to sell assets at rock bottom prices or draw down more of your super to cover the shortfall.
So work out what your living expenses are likely to be for the next year or two and set this amount aside in cash investments.
People with their own self-managed super fund have more flexibility to create their preferred asset mix and allocation to cash. Members of public offer funds may be restricted to choosing from a menu of pre-mixed options, although some funds allow you to hold direct cash and investments.
A bucket strategy
As well as market risk, recent retirees who can expect to live another 20-30 years or longer face the risk of outliving their investments.
A Rice Warner report on Preparing for a downturn highlighted the importance of having a mix of cash and growth ‘buckets’ to ride out a market correction and go the distance.
An example
Rice Warner tested four different investment strategies for a retiring member aged 65 with a $500,000 retirement super balance. Let’s call him Joe.
At retirement, Joe invests $500,000 using a bucket strategy. He allocates a year’s cash drawdowns (at the ASFA comfortable standard) to cash with 50% in a balanced portfolio to cover the following 10 years and 50% in high growth for the period thereafter.
The market correction results in a minus 15% return on the high growth portfolio minus 10% on the balanced portfolio. The funds recover back to their starting point after three years. Post recovery, the cash portfolio earns 2.5% a year, balanced earns 6% and high growth earns 8% a year.
Using this approach, Joe’s super lasts until he reaches age 90, in conjunction with a part Age Pension as his balance falls.
If he had crystallised his losses at the bottom of the market and switched to cash his super would have run out at age 82. If he had been invested conservatively in 100% cash or 50% cash at retirement, his super would have run out at age 84 and 87 respectively.
The upshot is that sticking to growth with enough cash for living expenses in the short-term will outperform investing higher proportions of your portfolio in cash or switching to cash at the bottom of the market.
Of course, this example is hypothetical. Everyone’s needs, circumstances and risk tolerance will be different, but the general principle is worth considering.
Plan to plan
The best plan for a market downturn is to have a plan you can stick to. Choose an asset mix that reflects your risk tolerance and make sure it provides the short-term cash and longer-term growth you need to live well for years to come.
If you feel you need advice, then look for an independent financial planner. For suggestions on where to look, see SuperGuide article Obtaining financial advice.
Learn more about preparing for retirement in the following SuperGuide articles:
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