This article explains why most retirees can no longer park their funds entirely in conservative assets and enjoy a comfortable financial lifestyle. We explore the real-life impact of longevity risk and why it is important to retain some exposure to growth investments.
Australian retirees are facing a ‘double whammy’ when it comes to funding their retirement. On the one hand we, as a nation, are enjoying longer and healthier lives. On the other hand, recent record low interest rates have slashed the returns on the traditional bedrocks of post-retirement investment portfolios such as term deposits, cash management accounts, and annuities.
This is the dilemma facing Dave and Linda. On the point of retirement, these fit and active 65 year olds are looking forward to regular overseas travel while maintaining their comfortable lifestyle. They estimate this will cost them $80,000 per year, to be funded from their combined retirement savings of $1 million. Both are in good health and realise there’s a high likelihood that one or both of them could live well into their 90s.
Naturally, Dave and Linda’s first thought is about security and preserving their capital. This leads them to look at investing their funds in a portfolio mainly comprising income-producing investments that will spare them from the volatility of share and property markets. However, they quickly discover that, with low interest, it will be difficult to achieve a return of just 3% per annum. A simple financial calculation shows that if they draw $80,000 each year from a portfolio with this low rate of return, the money will run out in just under 16 years. This strategy will see them barely make it into their 80s.
Time for a rethink
This highlights to Dave and Linda that the risk they will outlive their money (longevity risk) is as much of a threat as investment risk. To address this, Dave and Linda consider a portfolio that, while retaining some conservative investments, apportions most of their funds to a well-diversified range of growth assets including property, Australian and international shares, and some higher-yielding income funds. With an estimated return of 7% p.a., Dave and Linda’s money is calculated to last just over 30 years, seeing them well into their 90s.
Balancing the risks
Yes, a growth portfolio is, from an investment point of view, higher risk than a defensive or conservative portfolio. That is, it will be more volatile, rising and falling in value along with investment markets. Dave and Linda will need to accept this volatility if they want to meet their lifestyle goals. However, even 10 years is a long investment horizon, let alone 30, so with time on their side they should be able to ride out any market downturns.
And there’s another safety net. The above calculations ignore any age pension. As Dave and Linda draw down on their savings, they will probably qualify for some age pension in the future. In addition, Dave and Linda may decide to downsize in the future and free up more capital to invest to fund their retirement.
Not only will this offset some of the investment risk, but it will also substantially extend the date when their savings will eventually be exhausted.
Establishing a well diversified, considered portfolio is a little more complex than setting up a conservative portfolio. It will also require more active monitoring and regular review. On top of that individual circumstances can change quickly, particularly in older age.
For help with all aspects of retirement planning, including portfolio design, the establishment of income streams, and age pension strategy, give us a call.
The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.