Seven retirement challenges that need a different focus
In the past, most Australians have been in accumulation phase of superannuation, with the primary objective of building wealth. But that started to change when the first of five million Australian baby boomers began to hit retirement age. Every day, another 800 baby boomers retire, and the result is that a large proportion of the population now has significantly different investment needs than in the past.
Unfortunately, most funds are not sensitive to the unique needs and challenges of post-retirement. Super funds are offered indiscriminately to all investors, both accumulators and retirees, and simply focus on a total return outcome, and attempting to beat their respective benchmarks.
Amid a suite of possible investment strategies and tactics, we believe there are seven key factors that are vital to shifting an investment approach’s focus from accumulation to one more suitable for retirees.
1. Limiting large losses
While younger people can weather steep falls in markets and can even take advantage of them by buying low, retirees – with no future contributions to make and without the luxury of time to wait for markets to recover – could be forced to sell assets at low prices to fund their retirement.
Therefore, retirees (or their fund managers), need to be aware of how large negative returns could become in any single stress event and they need to be actively managing that downside risk, particularly at the start of retirement.
One way to do this is to invest in portfolio protection, typically in the form of equity options, which can help to mitigate the risk of a large loss by smoothing returns.
2. Managing behavioural risk
Human instinct can be our own worst enemy and the natural response of a ‘flight to safety’ can destroy significant wealth if applied to financial markets. To exacerbate the issue, non-advised investors can easily access and change their investment mix via super fund online portals or directly via SMSF structures, which means that investors managing their own investment strategy can more easily fall victim to their behavioural
In our experience, investors are much less likely to be reactionary if they have clear goals set for retirement, are aware of the types of losses they could incur in a single market event, have portfolio protection (as discussed above) in place, and are aware of other actions they can take to combat poor performance such as adjusting their lifestyle or potentially increasing their risk exposure.
3. Focussing on income over growth
An investment strategy that prioritises income over growth offers significant benefits to retirees.
The primary benefit is matching their cash flow needs with assets that continually produce cash flow via dividends, coupon payments or rent. Additionally, when income in equals expenditure out, investors have less need to sell underlying investments to fund their lifestyle, allowing them to ride out market volatility and reduce transaction costs.
However, investing for income can be overdone; what is needed is a balanced approach that invests in quality assets with resilient income streams and stable capital values.
4. Managing duration
Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates, expressed as a number of years. For example, if a bond has a duration of five years its price will rise about 5% if its yield drops by 1%, and its price will fall by about 5% if its yield rises by 1%.
As the objective of retirement savings is to fund the retirees’ future outflows, it is essential to understand how both the value of those outflows and of the retirees’ current assets would be affected by changes in interest rates.
To remove uncertainty around interest rates, the duration sensitivity of the assets can be matched with that of future consumption; this is referred as asset-liability matching. Or if there is an expectation that interest rates will rise in the future the portfolio can be actively tilted towards shorter-duration bonds, which have less interest-rate risk.
5. Inflation awareness
When in accumulation phase, inflation is not such a big threat because as the cost of living rises, so do earnings. But it’s a different story for retirees as an inflation spike means they pay more for their basic living expenses, such as groceries and utilities, without a rise in income to help meet those additional costs.
Yet many retirees are invested in conservative and moderately conservative index funds which have a large exposure to government bonds and duration, which underperform when inflation spikes.
Instead, retirees should hold assets that work to combat inflation risk such as inflation-linked bonds (rather than nominal bonds) and tilt toward sectors that have revenues linked to inflation such as infrastructure, property, energy and agriculture.
6. Managing liquidity
For investors, liquidity is the ease with which they can exit an investment at a favourable price, with reasonable fees and in a timely manner, should they need their funds immediately. As unexpected costs do arise in retirement (often in relation to health) having a strategy to manage liquidity in retirement is important.
Given the illiquid nature of property and some annuities, the retiree’s account-based pension is typically the first point of call for emergency funding. If invested in a managed fund, the retiree should check that it offers daily liquidity, can be sold at a reasonable ‘sell spread’ and 90% or more of its holdings are in liquid assets.
If, in addition, retirees hold direct investments, they should also be aware of their portfolio’s combined liquidity profile.
7. Tax awareness
Some retirees might think that they don’t have to worry about tax given they are no longer working, but by investing retirement savings in a tax-aware manner, the result can be a boost in income.
Franking credits – the tax credit investors can claim for tax already paid on a company’s corporate earnings – became refundable in the early 2000s.
Investors who pay lower tax (including retirees) receive a cash payment for the difference between any franked rate of dividend income and their individual tax rate. For retirees on a 0% tax rate, they receive an uplift of up to 43 cents on each dollar of fully franked dividend. For every 70 cents of dividends, investors can receive a tax credit of up to 30 cents, which equates to 43 cents per dollar of dividends.
During the dark days of the global financial crisis many retirees panicked and sold out of investments at the worst possible time. But even more concerning were the stories of retirees scrimping and living below the poverty line, worried about their future.
Our investment approach for retirement has for too long been modelled off the approach developed for younger accumulators, yet the risks that need to be managed are vastly different.
By considering these seven factors we will be more likely to have a generation of retirees who are confident in their investments, more likely to stay the course and able to enjoy the best retirement they can afford.
Darren Beesley is a Senior Portfolio Manager at AMP Capital. This article has been prepared for the purpose of providing general information, without taking account of any particular investor's objectives, financial situation or needs.
This article originally appeared in Cufflelinks, a free online financial newsletter that can be accessed via the following link: https://cufflelinks.com.au/newsletter-invite/