03/10/2020

Super savers with a large share exposure are enjoying strong gains but retirees with more conservative assets will struggle to make their nest egg last.

Mercer wealth leader Simon Eagleton says lower for longer is the general term used to describe the post-global financial crisis environment where interest rates, bond yields, inflation and economic growth have all been lower and are expected to remain lower than historical averages. As a result, prospective investment returns are reduced.
On the upside, lower inflation (both actual and forecast) means that although investment returns are likely to be lower, real returns are not falling as much as people think, Eagleton adds. And as such, the spending power associated with a given level of investment return is higher than previously assumed.
Forecasts to the test
The upshot of lower for longer is that previous assumptions about how much superannuation one needs to retire may not stack up.
The strategies of retirees, in particular, may need to be revised to reflect this new normal.
Darren Beesley, the head of retirement solutions at AMP Capital, predicts the return on a simple portfolio of Australian bonds and shares is likely to be less than 5 per cent a year over the next decade.
Let’s say retiree Shirley has a super balance of $500,000 and invests half in Australian bonds and half in Australian shares (see graphic).
Based on the average market return of 11.9 per cent over the past 50 years, Shirley could have expected to receive a comfortable retirement income ($43,000 a year for a single person according to the Association of Superannuation Funds of Australia’s retirement standard) for 18.5 years.
But for retirees in 2019, with returns calculated at 4.9 per cent, the money is likely to run out five years earlier (that is, after 13.5 years rather than 18.5 years).
“The bottom line is retirement savings won’t last nearly as long as they have in the past,” Beesley says.
Note that this example does not include the means-tested age pension, which would serve to supplement income once the retiree’s balance dipped below a certain level. Even so, it’s a powerful illustration and the sort of conundrum that’s keeping people up at night.
Beesley says investors can use online tools to do the sums on the adjustments they will need to make in the lower-for-longer climate. Just make sure whatever tool you are using has been updated to reflect more recent assumptions about returns.
The extent to which investors will be affected by lower for longer differs according to life stage.
Time advantage for accumulators
The group we might call “super accumulators” have time on their side. People in this group are still working and contributing to super and, as long as their super has been in a well-diversified growth option, they will have received higher-than-expected returns over the past five to 10 years, Eagleton says.
“Indeed, calendar year returns for 2019 look to be extraordinarily large due to the significant cut in global interest rates we have witnessed,” he says.
“In one sense, this is a ‘bringing forward’ of returns. That is, to the extent that investors can ‘save’ these higher returns they are well placed to withstand a probable reduction in future returns.”
People in this group may also be able to make extra contributions to super.
Retirees in drawdown or pension phase are much more susceptible to the ill effects of lower for longer because stashing extra money in super is typically not an option.
A key question for this group is whether to reduce spending, which means downgrading lifestyle expectations, or changing investment strategy.
“The first decision is to ensure you have your investment portfolio suitably diversified with enough exposure to higher-returning assets,” Eagleton says.
“If the answer is ‘yes’, then increasing your risk is not recommended. Investors should not chase higher returns, and should be very wary of products and strategies that promise unusually high returns. It’s important to think about ‘saving’ recent strong gains in your portfolio, thereby boosting capital and enabling you to tolerate lower prospective returns.”
Indeed former treasurer Peter Costello, who chairs the $166 billion Future Fund, this week warned that record low interest rates were pushing investors into riskier financial products. Some, he said, were like the “collateralised debt obligations” that caused all the trouble during the 2008 global financial crisis.
Eagleton says retirees who have their investments in cash should reconsider their portfolio asset allocation to gain at least some exposure to growth assets. Another must for retirees is to ensure they are taking full advantage of their tax-exempt status and access to franking credits.
Retiree choices
For retirees in draw-down phase, Beesley says there are four options.
The first is make no adjustments to lifestyle and accept that returns from the defensive side of portfolios are going to be lower than the past decade or two. Retirees in certain income brackets may rely on the government age pension sooner, he says.
Spending less is the other option. “People can start to adjust their spending based on their forward-looking returns,” Beesley says. “There are some online tools that can help.” ASFA’s retirement standards also contain detailed breakdowns of retiree spending.
A third option is to take more risk, but that’s unwise for people who are already retired, Beesley says. “Maybe early in life you can afford to take more risk and right now 20 to 30 year olds could justify holding even fewer bonds in their portfolio and taking on more equity exposure. But for retirees, it’s not recommended.
“We saw in 2008, with the global financial crisis, the damage that can be caused permanently to people’s retirement prospects. Losing 20 to 30 per cent of your retirement savings is impossible to recover from.”
A fourth option is to look for return in different places, Beesley says. This might mean taking a more active approach to investment management. Doing this requires a change of mindset from recent years, where the trend has been toward passive management to keep fees lower. It also means, counter-intuitively, diversifying away from simple equity and bond allocations which have performed so well in recent years.
“At AMP, we’ve been tilting into government and private infrastructure funding as an alternative to the traditional income stream from corporate and government bonds,” Beesley says. “People with SMSFs could perhaps look at property.”
Either way, this is not something that’s easily or safely done without some professional advice, Beesley says, adding that although it seems counter-intuitive, the lower-for-longer environment may well be the time to spend more on professional advice and external funds management.
“The ‘if it ain’t broke don’t fix it’ approach is dangerous right now,” Beesley says. “In the past, holding a very simplistic passive portfolio of bonds and equities worked very well. However, with record low cash rates and bond yields, now is the time to start thinking about alternative styles of investments and perhaps leaning more into professional investors to find sources of return that are going to boost your retirement savings. Cash is not going to work.”
Income tweaks
Of course, one of the most difficult tasks that retirees face is figuring out how much to draw as income each year. It’s a task made more difficult when returns are low.
But State Street Global Advisors head of investments Jonathan Shead has a suggestion worth considering.
Australians who choose an account-based pension must by law draw down a certain amount of money each year. The minimum payment is calculated at the start of the financial year as the account balance multiplied by a percentage that increases with age. It starts at 4 per cent for retirees under 65 and increases to 14 per cent for those aged 95 and over.
Shead says in the lower-for-longer environment it might be useful for retirees to think of income as a percentage of their balance rather than a fixed-dollar amount.
In this regard, the ATO’s minimum withdrawal calculator is a surprisingly sensible way to deal with both poor investment returns and living longer.
“Poor investment returns mean that your account balance is lower than you, or your financial adviser, expected,” Shead says. “But the minimum drawdown table applies a percentage to your now reduced account balance to determine your income. In other words, the minimum drawdown table automatically lowers your [account-based] pension if you have poor investment returns. And, of course, it increases your pension if your returns are better than expected.”
The table also adjusts for the “risk” of living longer than expected.
“The low percentages for younger retirees and high percentages for older retirees reflect different life expectancies,” Shead says. “For example, the minimum pension of 4 per cent of your account balance below age 65 suggest you will need payments for around 35 years. Contrast this to the 7 per cent minimum at age 80, which suggests you will only need payments for another 17 years.”
What does this flexibility look like in practice?
Let’s consider Jake, who retired at 65 with a lump sum of $500,000 and assumed he would earn 6 per cent in retirement and live to age 90 (see graphic). Taking inflation of 2 per cent a year into account, his initial annual income would be $32,000.
The blue bars in the chart show fixed pension payments at $32,000 a year in the early years of Jake’s retirement. The balance diminishes pretty quickly and runs out at about age 82. The green bars show what would happen if Jake uses the ATO table to reassess his income each year. The money now lasts much longer.
Unfortunately, there are no easy answers.
Considering the following question, posed by Beesley: At the beginning of which decade is it least desirable to retire 1970, 1980, 1990 or 2000?
“Most people will nominate the year 2000, which is a good answer because you had the sequencing risks associated with the 2001 tech wreck followed by the GFC in 2008,” Beesley says.
“But actually by far the worst decade to embark on retirement was 1970. The reason is because your purchasing power, your standard of living was depleted so fast by inflation in the 1970s that it actually turned out worse for you if youre buying a basket of goods every year.”
So what about this decade?
The fact that the defensive side of your portfolio which is so traditionally invested in cash and bonds is starting at such low yields means you cant get the kind of returns that people have come to expect,” says Beesley.
“If low inflation rates persist, this will help to some degree lighten the impact of low returns, but ultimately retirees need to adjust their expectations of future investment returns.”