Retirement can be an exciting time in your life as you look forward to stopping work, sleeping in and taking your time to do those unfinished jobs. It can also be a daunting time for some as they consider their income needs and whether or not they will be able to afford for their retirement in the future. Whether you have enough money or not, when approaching retirement, it is important to consider the all the risks that follow you into retirement.
Here we will explore some of the risks that pre-retirees will need to consider. Most risks can be controlled and/or mitigated all together. Taking a closer look at the risks of retirement can allay some of those fears that some pre-retires will have. For those pre-retirees who are willing to acknowledge the inevitable risks and prepare for them will, more often than not, enjoy their retirement compared to those people who ‘live for the now’ with no thought of the future.
Heading into retirement can raise a slew of scary questions. Will unexpected expenses throw off your retirement plan? Could a market crash decimate your carefully built nest egg? Most important, do you have enough money to last you through your golden years?
Firstly, we will look at one of the biggest risks facing pre-retirees in our current time. Will retirees have enough income to support their current lifestyle? The drop in income is more than likely a result of financial risks inherent with investing: Market Risk, Interest Rate Risk, Inflation Risk and Sequencing Risk.
Next we will look at the risks that retirees need to consider that are not due more to their genetic make-up then to their surroundings: Longevity risk, Trust and Control.
Finally, we will look at legislation risk that continues to have a major impact on current and future retirees.
Article – How realistic are senior Australian’s retirement plans? (National Seniors Australia and Challenger, July 2014)
1) Market Risk
Market risk is known as non-diversifiable risk or systematic risk. It can have a serious negative impact on a retiree’s savings as returns fluctuate due to macroeconomic factors. Not only can poor performance in the market affect the balance of someone’s assets it can also have an impact on the income they derive from those assets.
Whilst stocks have substantially outperformed other investments over a period of time, they are usually the cause of much anxiety and stress for many investors due to the nature of those type of investments. Stocks will rise and fall over the years but they are usually recommended for most retires as part of a balanced portfolio. Through the GFC we once again witnessed the demise of many healthy portfolios and watched the impact this has had on people who were about to retire or had just retired. For those who were about to retire it meant putting off retirement, and for those who had just retired it meant either returning to work (if they could get work) and/or saying goodbye to their ‘confortable’ retirement that were planning on.
Just prior to and since the GFC there has been a great move away from ownership in direct equities into more secure holdings like cash and/or fixed interest products e.g., term Deposits. For those retirees who had ventured back into equities just after the GFC, they would have relished their good fortune with the rise of the markets once again. However, for those who had remained in cash and fixed interest products, due to their distrust of market performance in the future would have been starting to question their conservative decision to do so.
In the past the discussion would be around equities and the hope that they would not fall in value in the early years of retirement. A retiree who experienced poor market returns in the first couple of years in retirement would have a different outcome than the retiree who experienced good market returns in the first couple of years of retirement, even though the long-term rates of return might have been similar. Early losses can mean less income during retirement. Later losses can have a less-negative impact, as the individual may have a much shorter period over which the assets need to last.
Now retirees are having a different discussion. The discussion is about income returns and a consideration towards moving back into equities.
2) Interest Rate Risk
The world is in unprecedented times and Australia, whilst it avoided the worst of the GFC that affected most of the world, has not been able to avoid the impact that low interest rates is having on retirees. All around the world cash and fixed interest products are returning poor returns to the point where they are not even keeping up with inflation. Retirees have started to realise that having money in only one asset class, like cash or fixed interest, whilst it may have been safe to do so, is now becoming a noose around their necks, due to the poor returns they are producing.
Lower interest rates have reduced retirement income for many investors who have remained in term deposits since the CFC. Annuities yield less income when long-term interest rates at the time of purchase are low. Low real interest rates will also cause purchasing power to erode more quickly.
Lower interest rates can reduce retirement income, and can be particularly risky when people are depending on drawdown from savings to finance their retirement. On the other hand, retirees have seen the equity market rebound and bring with it higher yielding income returns then their cash counter parts. Even the more conservative retirees are starting to look beyond term deposits to other asset classes. Either that or go back to work. For most retirees going back to work is not an option.
3) Inflation Risk
Another key risk is inflation, the increase in the cost of goods and services that diminishes the purchasing power of your money over time. With an inflation rate of just 3% per year retirees could lose half of their purchasing power over two decades if they do not protect against inflation. It is a major issue for those investors living on fixed income products like term deposits that don’t provide a hedge against inflation. With current interest rates being so low, having money currently in term deposits, amounts to throwing your money away, albeit slowly, with no chance to recover the losses that ensue.
To guard against inflation, retirees need to consider investing in inflation-protected assets that will growth in value over time.
4) Sequencing Risk
Sequencing risk is the risk of withdrawing money from your investment balance in unfavourable times. Retirees need cash flow from their investments in order to meet their daily living expenses and future one-off goals. If the markets are down and you are withdrawing large amounts of funds you are less likely to gain from the rise when the markets do turn. So what do you do when the markets have been done for a long period of time or if you are invested in fixed interest products that are providing poor cash returns?
For retirees, the solution is to diversify your portfolio into assets that keep abreast of inflation and keep a cash reserve in place. The discussion should not be about term deposits versus equities or equities versus property but about diversification. Those who have survived the GFC and are still earning a relatively good income from their portfolios are those retirees who have diversified their asset positions across several asset classes and geographical regions. Their portfolios consisted of money across several asset classes that included a healthy mix of stocks, term deposits, commodities and real estate, with no outsized holdings in one company’s stock. On the equity side, a portfolio would be allocated among several asset classes, geographic regions and companies of various sizes. It should reflect a combination of value, growth and dividend-paying investments. On the fixed-income side, it would be invested in products with varying maturity dates. This helps avoid the fixed interest products from maturing all at the same time. Don’t overlook the possibility that your investments will mature at an inconvenient time. It’s not unusual for a term deposit or a bond to expire at a time that is undesirable, when interest rates are low, as we are currently experiencing.
To avoid sequencing risk you can place funds into long-term annuities that pay a guaranteed income return or into investments that insure against market decline. Alternatively, you can keep a side a cash reserve of up to two years worth of living expenses. These funds can be used when the markets are down so that you don’t draw upon the rest of the portfolio, which has time to ride the market and regain some gains after a decline. When it’s up, you can sell your investments at a profit.
For pre-retirees the discussion should not only include diversification but dollar-cost averaging. Dollar-cost averaging is where you purchase your investments regularly over a long period of time. When markets are down you are purchasing more equities at a low price and fewer equities when the market is high. It helps to even out the purchase price of the stocks being purchased as well as remove the ‘fear’ and ‘greed’ mentality that is so common with investing. Dollar-cost averaging is not about guessing the market but about making the regular purchase regardless of how you are feeling – through the good and bad times.
Lastly, pre-retirees need to consider cash flow before growth. If you have a mindset towards purchasing assets to derive an income regardless of the value of that asset then you will do well over the long term. Holding on to assets to derive an income compared to trying to time the market to make a capital gain is always going to win over the long run.
Inflation Risk (http://www.investinganswers.com/inflation-risk-974)
Interest Rate Risks (http://www.investinganswers.com/financial-dictionary/bonds/interest-rate-risk-979)
Article – OMG_Sequencing Risk (Challenger, One Minute Guide, September 2012)
The Risk you bring
1) Longevity Risk
One of the primary concerns for retirees is that they will run out of money before they die. Simply following the life expectancy tables to determine the life expectancy of a person is hap hazardous to say the least. The life expectancy tables only show the average age someone will leave to. Which means that half the population lives longer and the other half live a shorter life. Based on the life expectancy tables, the older you are now the more chance you will live longer. Currently, it is estimated that a male aged 65 today will live to about 85 years of age and a women about 88 years of age. Again, these are averages as we all know of people who have lived longer.
It is important to try and estimate how long you think you will live and manage your savings accordingly. Spending too much in the early years might result in no money in the later years and spending hardly anything in the early years might result in a stockpile of money that could have been used to enjoy ones retirement. It is a balancing act and one that not many retirees get right.
How do you mitigate the risk of longevity?
A lifetime annuity, whilst not the ideal product, if you want to pass something on to the children or have control over the investment, will provide certainty of income for retirees until they pass away. Retirees need to consider how they will invest their money to make sure it sustains them for the many years of retirement to come and not simply go on SKI (Spend Kids Inheritance) holidays and then rely on social security benefits…they just might not be around.
Life expectancy. Australian Institute of Health and Welfare (http://www.aihw.gov.au/deaths/life-expectancy/)
Article – How long you live determines how much money you need (Challenger, One Minute Guide, July 2012)
Everyone has been hurt at some point in his or her lifetime. Hurt leads to a loss of trust in people and can destroy relationships. It is hard to rebuild trust in the person or organisation that has already lost it. Whilst everyone deserves a second chance and we should forgive those who have hurt us, it can take a lot of time before bridges can be rebuilt. Unfortunately, for some people, it can be very difficult to rebuild those bridges, especially when money is involved.
How can you protect yourself?
Education is the key. It is important that people educate themselves as much as possible. Having a greater understanding about what is happening with your money helps to reduce the risk of getting hurt. You will know the difference between an honest mistake and a mistake caused by mistrust. Let’s be honest, no one is perfect and mistakes will occur but the more wisdom (education) you have the less likely the mistake will have a significant impact on your life compared to the person who does not understand what is happening. Educating yourself enables you discern between a person who is selling a product and a person who understands their industry and what you might need. At the end of the day, the world is neutral and affects everyone the same way. It is ultimately your responsibility and the decisions you make that will determine the type of retirement you will have.
So educate yourself, make a decision to trust someone to look after your affairs, and enjoy retirement.
Trust and Control work hand in hand. In order to pass over control you must feel a level of trust for the person who is going to be looking after you. More and more SMSF are being set up because people want greater control of their financial situation because ultimately they have lost trust.
It is important to let go and pass over control to someone else. Trying to micro-manage every single thing that is happening in your life will just bring stress and heartache. Why? You will start to question your own decisions and lose trust in yourself. Every day will be about whether you are making the right decisions rather than living for the now and enjoying the ‘present’. The ‘present’ being family, friends and what life has to offer, even in retirement.
Don’t blindly follow someone and give over complete control. Again, it is about educating yourself and then letting someone else do the work.
Legislation risk also brings a lot of uncertainty for retirees. Every year changes are made to superannuation and/or social security. These changes can have a significant impact on retirees. For instance, recent changes to the asset and income test for the Age Pension will result in many retirees losing their pensions.
Changes to support for pensioners and retirees. (http://www.aph.gov.au/about_parliament/parliamentary_departments/parliamentary_library/pubs/rp/budgetreview201415/pensioners)
Budget 2015: Age pension eligibility criteria tightened in ‘sustainable’ overhaul (http://www.abc.net.au/news/2015-05-07/budget-government-to-outline-changes-to-age-pension/6450946)