BY ALLIANZ RETIRE+
Republished from adviservoice.com.au
As investors transition from accumulation to decumulation, their investment objectives change from amassing wealth to generating retirement income to meet their lifestyle goals. The risk-return landscape also transitions, from ‘maximising returns for a given risk tolerance’ to ‘creating greater certainty of income’.
As such, the risk-return landscape becomes more complex; this greater focus on using accumulated wealth to sustain a level of income throughout retirement requires careful planning, a meticulous focus on asset allocation to both sustain capital and generate income, as well as risk management.
Consider the following:
almost 10% of Australians have retired poor
financial challenges for retirees are increasing along with average longer lifespans, and
retirees find it extremely difficult to manage savings over an unknown period of time as factors such as sequencing risk, market volatility and inflation introduce extreme uncertainty into long term planning
An important part of retirement planning is to educate clients before they retire, to ensure they understand the risks each may face and the potential implications for their retirement income and lifestyle.
Know the risks
Some risks come with some degree of control for most people: the timing of retirement, the amount of retirement savings and, once retired, the rate of withdrawal. Each can be influenced by you or your client. However, unforeseen circumstances can often result in early retirement, while unexpected financial constraints may reduce the amount of funds allocated to retirement.
Other risks cannot be controlled. Such ‘uncontrollable’ risks are often interrelated and may have longer term ramifications for your client: in isolation or together, these risks could impact their investment risk tolerance, see them reduce spending or necessitate unwanted lifestyle adjustments.
Controllable risks
There are several retirement risks that are often described as ‘controllable’, although that might not always be the case. Unforeseen circumstances can derail the best of plans, although ideally, personal insurance will provide a safety net, particularly for those forced to retire due to ill health or an accident.
Take the timing of retirement. In an ideal world, your client will identify their preferred retirement age and as guided by you, commence the transition to retirement at the appropriate time. However, 43 percent of Australians surveyed in 2021 were unexpectedly forced into early retirement due to ill health, accidents, carer responsibilities, job loss or business failure.
An unexpected and unplanned transition into retirement can rob people of their sense of control and leave them feeling worried and anxious. An unexpected early retirement can also derail the best-laid financial plans. In addition to losing their regular salary, involuntary retirees are left at the mercy of financial markets. This highlights the importance of early retirement planning; unforeseen circumstances can bring a client’s retirement date forward and see them less prepared to meet their longer-term needs.
A second controllable risk relates to the quantum of retirement savings and suggests that increasing contributions can mitigate the risk of insufficient savings. On the face of it, it’s a sound strategy; however, it’s not always possible for a client to increase contributions. There’s an increasing number of retirees taking mortgage debt into retirement or drawing on their savings to be the ‘bank of mum and dad’. The factors that can impact retirement timing can also limit the ability to make additional contributions; despite, this retirement planning should actively consider strategies to increase contributions to retirement savings as early as possible. Even a small increase in contribution can have positive long term impacts.
A third controllable risk is the rate of withdrawal. The higher the rate of capital drawdown, the faster retirement savings will be consumed. This will impact the client’s ability to meet their basic and psychological needs, as well as their lifestyle and wellbeing. However, there are minimum drawdown requirements to be met and personal circumstances can change, both of which can impact retirement planning and the longevity of savings.
Uncontrollable risks
Given the uncertainty of life and death, it’s impossible to work out precisely how much retirees can afford to draw down each year. Instead, many retirees face a tough decision: should they live more frugally, or risk running out of money?
The additional uncertainty around future investment returns throws a further complication into the mix.
Australians cannot simply plan their retirement based on contemporary market movements as they need to account for unknowable future market returns. As highlighted by the Retirement Income Review, Australian retirees are dangerously exposed to longevity risk, which is in turn affected by several factors, namely:
Sequencing risk
The market conditions that prevail in the years just before and after a person retires can make an enormous difference to how long their funds last. Those crucial years are often called ‘the retirement risk zone’; a period when retirees are most vulnerable to market volatility.
If someone is fortunate enough to retire in a period of upbeat markets, then their income drawdowns will be fully or partially offset by investment returns.
However, if the ‘retirement risk zone’ (see figure one) coincides with a period of negative returns, retirees may start eating into their savings at an accelerated rate, potentially emptying the nest egg. Market shocks during the vulnerable period will leave Australian retirees with less time to recover, while falling asset prices and drawdowns for income can magnify the scale of capital losses.
Ultimately, any losses will diminish the total value of the remaining assets.
Retirees have no control over the sequence of returns, that is, the order of years with positive or negative returns. In a perfect world, Australians would retire only during periods of reduced volatility when their investment outcomes can be planned for with a greater deal of certainty.
Market risk
The GFC, which saw the ASX 200 lose roughly 54 percent of its value between 2007 and 2009, scared many Australian retirees. Research by National Seniors Australia carried out a decade after the crisis found 72% of retirees were afraid they would face a similar crash in their lifetime.
More than half (59 percent) said they would not be able to tolerate a crash of that magnitude. In 2020, many came close to experiencing a GFC-like event. As the Covid-19 pandemic spread across the globe, markets reacted violently with the ASX 200 index losing 35% between 20 February and 23 March.
The timing, as well as the size, of a crash can have dramatic consequences. As modelled in figure two, the prevailing market conditions at the time of, and after, retirement can determine how long a retiree’s capital could last when investing in a balanced portfolio. It was chance that dealt 1982’s retirees buoyant markets, and chance that presented 1929’s retirees with a crash and rapid capital depletion.
Because retirees usually can’t align their retirement date with ideal market conditions, the decision (forced or not) to leave work can be a big gamble, particularly without the right mix of strategies and products. Unfortunately, chance can have a much greater impact on retirement outcomes than good planning.
A significant capital loss requires a significant gain to get back to the same point. As illustrated in figure three, there is a nonlinear relationship between gains and losses; as the loss grows, the gain required to restore the loss escalates.
Clients in the accumulation phase generally have the advantage of time to recover losses, as well as the opportunity to invest more during market downturns, taking advantage of lower priced assets. Unfortunately, a retiree in decumulation phase does not usually have this opportunity.
Inflation risk
Inflation risk is once again top of mind as Australia’s cost of living spirals. Higher inflation can reduce retirees’ purchasing power and introduces the risk that spending needs in the future will be higher than originally planned. This, in turn, may exacerbate the fear of running out of money and increase loss aversion.
The compounding impact of inflation over time can erode retirement savings. Figure four uses the example of a retiree with $500,000. An annual inflation rate of 5% would result in their savings running out 10 years sooner than if inflation stayed at 2%. Concerns about inflation and rising costs are top of mind for many pre-retirees; for those already living on a fixed retirement income, the figure is likely to be much greater.
Behavioural Risk
Also referred to as ‘loss aversion risk’, behavioural risk can impact how a retiree invests, how much income they draw and can even impact their lifestyle. A range of behavioural studies have illustrated traits and biases that can impede your clients from making reasonable decisions about their retirement savings.
These biases might stem from others’ experiences, the fear of outliving their savings or the fear of losing capital. Research from Investment Trends identified three retirement fears, pertinent in the current environment.
While loss aversion is a major factor influencing investor behaviour, particularly in retirement when it’s difficult to recoup losses, understanding other biases and fears that may negatively impact your clients’ decision making is essential to retirement planning.
While many retirees may be willing to reduce the probability of negative returns at the expense of upside potential, they also need to understand the potential long-term ramifications of reducing exposure to growth assets.
Money anxiety is a health concern
Given the prevalence of these risks it’s no surprise that funding post-work lifestyles is a cause of stress for Australians close to retirement. CoreData figures suggest two-thirds of pre-retirees are concerned they will not have enough savings to retire comfortably.
In the ABC ’Australia Talks’ survey from 2021 of nearly 55,000 people of all ages, 55% of women and 42% of men said they were either not at all confident or not very confident that their savings would last.
Health authorities note that worries relating to money are a leading source of stress in Australia and can lead to depression and anxiety, compounding the health issues many retirees face as they age. So it’s not just lack of money that’s a concern for retirees, but the fear and uncertainty it results in.
Retirement risks are interrelated. Volatile financial markets lead to market risk and sequencing risk, while inflation can be the catalyst for both. Inflation can increase longevity risk and impact retiree’s behaviour, making them more loss averse or leading them to live more frugally. While some of these risks can be managed by educating your clients, they can also be managed – wholly or in part – by careful portfolio construction.
Constructing a retirement portfolio can be complex – retirees need capital, income and flexibility as their circumstances change. One approach is to incorporate both capital protected and guaranteed income products. Capital protected products can help safeguard against market risk, preserve capital and often provide a reliable source of income. Guaranteed income products can also provide a steady income stream throughout retirement. By combining such products, you can create a diversified portfolio that balances risk and reward, helping to ensure a comfortable and secure retirement for your clients.
The financial services industry now has a clear opportunity to optimise retirement strategies in a development that would dramatically improve the quality-of-life, and emotional health, of countless Australians. Businesses offering retirees tailored products designed around the concepts of flexible guaranteed lifetime income with ongoing access to capital will lead the way.
Adviser Voice is a platform providing education and information to Australian financial advisers.
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