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The COVID-19 pandemic has disrupted the global economy and financial markets to such an extent that the consequences will be felt for many years.
A time of uncertainty
Global recession and escalating trade tensions between the US, China and the rest of the world have increased geopolitical risks. While in Europe, final Brexit arrangements are proving as elusive as ever.
In Australia, the Reserve Bank has almost exhausted its firing power after cutting interest rates to close to zero. Federal and state governments have unleashed billions of dollars in financial support and more can be expected to get the economy moving again.
While the RBA is focused on stimulating the economy, low interest rates have taken the wind out of the sails of retirees and anyone who relies on income from bank deposits.
Shares have recovered much of their early COVID-induced losses, but many companies have postponed or cut dividends to shore up their balance sheets for uncertain times ahead. Investment property has held up well considering, but rents and demand are likely to stay soft due to a halt in migration, rising unemployment and corporate insolvencies.
To say the outlook for investors is challenging is an understatement. Especially so for anyone trying to put the finishing touches to their retirement plan or living off the income from their investments.
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 plunge in February/March 2020 dragged down super fund balances. It gives the example of a member with an account balance of $500,000 in the median Balanced investment option at the end of August 2019.
By February 2020, this member’s balance would have grown to around $527,000. Happy days. Then COVID struck, knocking 13% off their savings to a low of around $457,000 in March. At this point, many people panicked and switched to cash or a more conservative investment option.
If our hypothetical fund member switched to cash in March, by the end of August 2020 their savings would have flatlined to be worth $457,538. If they had switched to the median Capital Stable investment option, their account balance would have recovered to $479,038. This is just over $20,000 less they had 12 months earlier, but at least they would have slept a little easier.
However, if they had stayed the course and remained in the Balanced option their account balance would have recovered to $503,098 by the end of August 2020; a slight increase on their $500,000 balance 12 months’ earlier.
But what would have happened to someone who retired in March 2020?
Without the ability to make additional contributions once they shift to retirement phase, they would be forced to start withdrawing income from their depleted savings. Depending on the size of their balance, they could run the risk that their money would run out earlier than planned.
And if an aversion to risk led them to choose a cash option, they would limit potential future growth in the value of their underlying investments.
This simple illustration highlights three concerns for members close to or in retirement:
- Timing, also referred to as sequencing risk. To learn more see SuperGuidearticle 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.
While the COVID pandemic wiped 37% off global sharemarkets in February/March 2020, the falls were much lower for well-diversified super funds. Even so, funds reported members switching to cash and conservative investment options throughout March and April.
This was a repeat of investor behaviour during the GFC in 2007-08, after which many did not return to their previous investment option for years, if at all. In the long run, then and now, they may have been better staying the course.
According to SuperRatings, the median return for Balanced pension funds fell 10.2% in the March 2020 quarter. The median Capital Stable pension option fell 3.8%. Returns over the ensuing months recouped this loss, with both Balanced and Capital Stable pension funds returning 0.9% in the year to August 2020. But over ten years, Balanced funds significantly outperformed, returning 8.4% a year on average compared with 5.7% for Capital Stable funds.
Resist the itch to switch
Kirby Rappell says anecdotal feedback from super funds is that roughly half of those members who switched to cash in March/April 2020 had switched back to their previous investment option by September. Unfortunately, many would have missed the best of the upswing, while members who remained on the sidelines stand to lose even more.
“The challenge is not just when to switch out but when to switch back in. It’s hard to time the markets – if it was easy, we’d all be doing it,” says Rappell.
Research by Fidelity shows the financial cost of missing out on just a handful of the best days for the share market over a given period.
A hypothetical $10,000 invested into the ASX 200 Accumulation Index (share prices plus dividends) on 30 October 2003 would have turned into $37,735 by 6 September 2020.
Missing the ten best days during this period would have reduced returns by $15,375, while missing the 20 best days would cut returns by $22,930.
Of course, most super members are invested in a well-diversified fund which dampens the effect of a big fall in any one asset group, such as shares. This is another reason to be cautious about making impulsive decisions to shift your super to cash after a sharemarket fall. As the saying goes, act in haste, repent at leisure.
So what is the potential cost to your future retirement income of switching your super to cash during the COVID-19 market turmoil and not switching back for some time, if at all?
The long-term cost of switching
Recent modelling by Willis Towers Watson found that switching from a Balanced investment option to cash in March 2020 and not switching back for ten years had a greater impact on retirement outcomes than taking $20,000 in early release payments or being unemployed for three years.
Nick Callil, head of retirement solutions at Willis Towers Watson, says there is a lack of data on how long it takes super members to switch back from cash to a more diversified investment option.
“Anecdotally, after the GFC some members who jumped out of the market didn’t get back in for a long time,” he says. The study – Impact of COVID-19 on Retirement Adequacy – settled on ten years to reflect this lengthy delay.
After modelling outcomes for hypothetical individuals of various ages and income levels, the study found that switching is particularly damaging for older members on middle incomes. This reflects the impact of investment returns in the ‘retirement risk zone’ in the years immediately preceding and after retirement.
As the table below shows, someone aged 60 on a middle income was on track to have retirement income equivalent to 94% of the ASFA comfortable standard to age 90 pre-COVID. But switching would reduce this to 76% of the comfortable standard. (ASFA’s estimated budget for a comfortable retirement is currently around $62,000 a year for couples and $43,700 for singles.)
By comparison, members aged 30–40 would exceed the comfortable retirement income standard despite switching, while a member aged 50 would achieve around 96% of their retirement income target.
Impact of switching on achieving a ‘comfortable’ retirement
|Age 30||Age 40||Age 50||Age 60|
|Post-COVID (after switching)||111%||103%||96%||76%|
Source: Willis Towers Watson, modified by SuperGuide
While higher income earners have more to lose in dollar terms by switching, their greater super balances mean they would still easily meet the ‘comfortable’ retirement standard. Whether this would be acceptable for wealthy individuals is debatable.
Low income earners have less to lose in dollar terms and overall impact on their retirement income, thanks to the Age Pension. For example, a 60-year-old low-income earner would have been on track to achieve 68% of the comfortable retirement standard pre-COVID, and 63% post-COVID after switching from a Balanced option to cash.
While some of the assumptions in this study may be debatable, and certainly should not be taken as a guide to your own retirement outcome, it does illustrate the potential long-term impacts of switching.
Know your risk tolerance
Financial adviser Russell Lees, founder of independent advisory firm Kauri Wealth and board member 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 increased the defensive component of client portfolios in late 2019 due to increased market risks and economic uncertainty. He shifted clients from a typical balanced asset allocation of 30% defensive/70% growth assets to 40% defensive/60% growth.
When the market fell in early 2020 he maintained that asset allocation, taking the view that the market would recover. Instead, he did some tweaking within portfolios. For example, after the annual reporting season he removed some defensive stocks in favour of quality growth stocks.
Lees says only two of his clients asked to be moved to a more defensive asset allocation in March 2020. Unfortunately, they missed the rally over the ensuing six months.
While knee-jerk reactions after a big market fall are generally a mistake, there may be times when it makes sense to alter your asset allocation. For example, many people move to a more conservative investment option as they near retirement.
Assess your liquidity needs
For retirees, another lesson from COVID-19, and the GFC before it, 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 and other liquid investments.
For example, Lees advises retired clients to have five to six months’ pension drawdowns in cash. He also ensures they have other investments in their defensive portfolio that can be sold easily to pay for an overseas trip or a car, rather than selling shares.
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 to 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.
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.
However, if the market tanks when you are close to retirement, you may need to adjust your plans to the new reality. Depending on your circumstances, you could choose to:
- Retire on a slightly lower income if you have more than enough super and other financial resources for your needs
- Make additional super contributions to rebuild your balance within your annual contribution limits if you have available income
- Work a few years beyond your preferred retirement date if that is feasible.