Risks in Retirement
At first glance, and certainly for those who remember the uncertainty and impact the Global Financial Crisis (GFC) had on retirement portfolios, many people regard investment risk as the single most important risk to retirement.
Investment risk refers to the level of volatility, or fluctuation in investment returns, an investor is prepared to accept. The word ‘risk’ has a number of connotations with regards to investments, however, there are three main risk factors to consider:
- The risk of losing your initial investment – for example, if you invested in a company or asset which is poorly managed and subsequently declined in value or went bankrupt, you could lose part or all of your investment capital.
- The risk of receiving a lower than expected growth return – for example, the value of an asset in which you have invested, such as a house or shares, either increases at a lower than expected rate or even decreases when you were expecting growth.
- The risk of receiving a lower than expected income return – for example, if you purchased shares and expected a dividend payout of 50 cents per share and you only received 10 cents per share.
With all the media noise, and emotions that are linked to investment market risk, what is often overlooked is the range of other equally (and perhaps more) important risks that are present in retirement planning. Before we get into the details however, we should be mindful of the following three key points that also need to be considered in the context of retirement planning in Australia:
1. As a result of improvements in health and lifestyle, life expectancies are continually increasing and as a result retirement is a longer timeframe. According to the ABS, more than half the people born this year can expect to live beyond 85 years of age whereas the average life expectancy of a 65 year old male in 1965 was only 12 years;
2. The age pension is currently an equivalent payment to approximately 27% of the average working wage. The maximum age pension is currently $20,664 p.a. for singles and $31,153 p.a. combined for couples however we also know that eligibility to obtain the full age pension is becoming more restrictive;
3. According to the ASFA Retirement Standard a retiree couple aged 65 should expect living expenses of approximately $59,236 p.a. (excluding medical / health related expenses) to live a comfortable lifestyle and $34,226 for a modest lifestyle – each assuming they own their own home (Dec 15).
Longevity Risk refers to the risk that a person may outlive their retirement funds and will therefore face a bleaker financial situation in the latter stages of their life.
If the life expectancy of a 65-year-old male is 16 years, statistically half that age demographic will still be alive at the 81 year mark. If, however, a retiree is basing their retirement income needs on a 16 year timeframe and they draw their income down with a 16 year duration in mind, and then they continue to live for say 6 years further, they may become solely reliant in the age pension for the remaining six years.
Whilst many would argue that the living expenses of an 81 year old are likely to be more modest than that of a younger retiree, the cost of medical, health care and the possibility of aged care accommodation are all considerably higher at age 81. Having less liquid capital for support during these years has the ability to limit choices and significantly lessen the quality of life.
Inflation Risk refers to the risk associated with investment returns not keeping pace with the rising cost of goods and services, thus reducing the purchasing power of the retiree’s income as the year’s progress.
The cost of a basket of goods purchased this year is likely to be higher than the costs of purchasing the same basket of goods three years prior. Therefore some level of inflation protection should be considered in the forward planning for all retirees. If an inflation rate is running at an average 3% p.a. (despite there being a wide range of inflation rates depending upon the goods or services) the purchasing power of money reduces by 3% per annum and over a period of 15 years, the value of one dollar at age 65 has been eroded by 35% as the purchasing power is now the equivalent 0.65c.
For those retirees who want to maintain their current standard of living, they will need to build in a level of inflation protection by investing in assets that will generate a level of investment performance that is sufficient to meet their current income needs and their future income needs. In the current low interest rate environment, this is not easily achieved without incorporating growth-oriented assets (shares and property) into their portfolio.
Sequencing risk is the interaction of volatility and cashflow requirements within a portfolio. For those approaching or having just entered retirement, a negative market impact on a portfolio in the early years can have a significant impact on the portfolio due to the investors’ requirement to commence drawing upon the portfolio to meet living expenses.
For retirees who require a set level of income drawdown, the known impact on a portfolio is a fixed amount being drawn and if this is done so from a lower overall balance, then it’s percentage impact can be considerable. For example, If a portfolio of $800,000 provides an income stream of $65,000 (8.2%) but generates a total return of 8% p.a. the portfolio is close to neutral in terms of inflows / outflows. However if the portfolio experiences an equivalent 8% loss in the first year (or just prior) thus reducing the portfolio to $736,000, the $65,000 p.a. income requirement now represents 8.8% of the remaining portfolio balance. This problem grows further in year 2 when you consider the portfolio then requires a total return of more than 16% p.a. to get the portfolio back to it’s original starting value of $800,000.
The retirement risk zone is that period in the financial lifecycle just prior to or just after the retirement of people with moderate (middle) means where the impact of market and sequencing risk is likely to have a significant impact on the value of their accumulated portfolio.
Contingency risk is the risk associated with any unforeseen and unexpected events that cause a higher than budgeted cashflow drain thus having a negative impact on an investor’s portfolio. Examples of which can be in relation to health, aged care costs and having to provide financial support to family members.
The implications of a deterioration in health for a pre / post retiree are that their portfolio is drawn upon to meet the cost – often significant cost – associated with medical treatment, change of domestic living arrangements and shortage of appropriate options. Often the deterioration in health occurs without warning and the response needs to be swift, therefore the financial impact is often a secondary consideration behind that of immediate care needs and quality of life considerations.
By setting aside a margin for contingencies, in the form of a financial pool, is ideal but often out of the question for retirees of modest means. Retaining wealth in the family home, which can later be sold and converted to cash for the purposes of paying for medical treatment and/or accommodation is often the most suitable option.
Political risk refers to possibility of future government policy resulting in a change to (or elimination of) benefits for retirees. Examples include increases in (or the introduction of new) taxes, reduction in entitlements to Age Pension and/or Medicare and the restriction of accessing accumulated retirement assets (in Superannuation / Pension phase).
One example of political risk is the announcement in last week’s Federal Budget effectively limiting the lifetime amount retirees can accumulate in a tax-free pension to $1.6m. For a pre/post retiree, ensuring there is a combination of Accumulated Super, Age Pension and other Voluntary Savings (see 3-pillars article) will reduce a heavy (or sole) reliance on just one component for future retirement income and reduce the impact that any future political risk may have on their plans.
If you would like to discuss any of the risks / issues raised in this article, please feel free to contact one of the Adviser fp team by (CLICKING HERE).
- Adviser fp / Lonsdale Financial Group
- Association of Superannuation Funds of Australia
- Australian Bureau of Statistics
- Australian Department of Human Services