When working out a retirement strategy, often people try to work out the value of investments they will need by multiplying the amount of annual retirement income they will need by a nominal interest rate. For example, if you want $100,000 p.a. in retirement and you think you can earn an income rate of say 3% p.a., you’ll need $3.4 million of net investment assets. The more aggressive you are with your interest rate assumption, the fewer assets you need to meet your goal. The reverse is also true.
Beware, there are a couple of pitfalls with this approach.
It results in a lazy asset allocation
If all of your investment assets are invested in cash or fixed interest investments (such as government and corporate bonds) in order to generate a stable income, you have little protection from inflation. This is because these investments do not provide any capital growth. All their return is provided in the form of income and your capital stays the same – think term deposit.
This means that over time, your assets will be worth less and less in real terms – because of inflation, your purchasing power is reduced. For example, $1 million today will be equivalent to $477,000 in 30 years’ time assuming the inflation rate averages 2.5% p.a. over that period.
People are living longer. Medical technology is improving at an increasing rate. Therefore, we must consider the likelihood of living to age 100 and beyond. To ensure you don’t run out of money, you must ensure you invest in assets that provide some capital growth so that your money at least keeps up with inflation and hopefully increases over time.
You must account for taxes
Of course, you must account for any taxation liabilities. If all your money is inside super (and your balance is less than $1.6 million), then no tax will apply if you draw a pension. However, if you have assets outside of super, you will need to account for any income tax consequences. The good news however is that an individual can earn approximately $20,500 per year before they need to pay any tax. Therefore, hopefully you can share any personal income between you and your spouse to minimise any taxation liabilities. My point here is you must think carefully about ownership structures i.e. where your investments are held. Super is excellent, but you don’t want to put all your eggs in one basket. Putting all investment assets in one person’s name also typically isn’t very wise in the long run.
Markets will go up and down
The role of asset allocation (i.e. the methodology used to spread your money across various asset classes) is to smooth returns and minimises losses. That is, some asset classes are negatively correlated which means when one asset class generates high returns, the other will likely generate low or negative returns. However, if you invest in both asset classes in the right proportions, you will achieve better investment outcomes at a portfolio level. This (i.e. asset allocation) is the most important decision a professional advisor can help you with. Its an investor’s most important decision. Because investors cannot control markets or returns. But they can control where and how they invest their monies.
Therefore, by putting all your money in cash and fixed income assets, you risk missing out on a lot of returns. Take the last decade for example. Government bond returns have been historically very low – sub 3% p.a. Whereas international equity markets have provided a total return of just under 10% p.a. over this period of time. This demonstrates the perils of putting all your money in one asset class.
Sometime in the future, this will probably reverse. Equity markets will perform poorly, and bonds will perform well. Therefore, we must invest in a way that positions our money to perform well regardless of how individual markets behave.
Maybe interest rates will be lower for longer?
There as been a lot of commentary since the GFC that perhaps interest rates will be a lot lower than they were in the two to three decades before 2008. Quantitative easing and loose monetary policy are two reasons that are cited for adopting this view. I am always cautious when anyone forms the view that history will not repeat itself – because it invariably does. Therefore, I do leave room for the possibility that interest rates (and more specifically bond returns) will one day rise above 3% p.a. However, equally, I leave plenty of room for the possibility that rates will be persistently low for a longer period of time. If this is true, then putting all your money in cash and fixed interest securities will be financially unproductive.
You risk overestimating the amount you really need
If you assume that all retirement living expenses need to be funded from investment income, you must therefore assume all your monies will be invested in income-style assets (cash and fixed interest). As such, you will need to be relatively conservative with your interest rate earning assumption, especially in the current environment (e.g. current term deposit rates are circa 3% or less). This will mean that you will need more wealth in order to achieve your goal.
However, if you assume that you will have a more diversified asset allocation e.g. a mixture of Australian and international shares and bonds, it is reasonable to assume a higher overall portfolio return (see more below). This will then mean you need less wealth to fund retirement than what you might have originally thought.
So, how do you fund retirement then?
Most people will not be able to fund retirement purely just from investment income – they will need a combination of income and capital growth – for the reasons discussed above.
This is achieved through developing an appropriate asset allocation target and then a long-term strategy to achieve that target by the time you reach retirement age. For example, an investor might aim to achieve the following asset allocation by retirement age:
- 30% of investment assets in residential property – assume net income will be 2% p.a. and growth 7% p.a.;
- 40% of investment assets in Australian and international shares (most of which are in super) – assume net income will be 3.5% p.a. and growth 3.5% p.a.[1]; and
- 30% of investment assets in cash and fixed interest assets (bonds) – assume interest rate of say 2.5%.
If the retiree has $2 million of investment assets, the above portfolio will, on average, generate $55,000 of income plus $70,000 of growth per year. If the retiree needs $100,000 for living, they will need to spend $45,000 of their cash holdings on living expenses. However, the retiree’s investment assets will increase each year by $25,000 (being income $55k + growth $70k less living $100 = $25k). Sure, they eat into their cash savings, but this is more than offset by an increase in asset values.
The weighted average return on the above portfolio is 6.25% p.a. Therefore, if an investor needs $100,000 p.a. in retirement, they need assets worth $1.6 million to break even. However, if we assumed that they were invested 100% in cash and earned an interest rate of only 2.5% p.a., they would need $4 million of investment assets. This demonstrates having a well-diversified asset allocation means you need fewer investment assets to reach your goal.
This is a simplistic example to illustrate my point. I am not suggesting that the above asset allocation is in fact appropriate as it depends on many factors.
What does this all mean?
I guess the biggest take-away from this blog is that it is best to acquire a combination of investment assets i.e. some property, some shares (hopefully in super) and some cash by the time you reach retirement. It is not necessary to acquire these assets equally each year. In fact, as this video demonstrates, you should acquire the property first, then shares and then cash. This is the why having a clear, simple, easy-to-follow investment strategy is so important – don’t leave it until it’s too late. Of course, if you would like to discuss your investment strategy with us, don’t hesitate to reach out to us.
[1] Whilst long-term share returns are circa 10% p.a., I have been conservative to account for the fact that shares have twice as much volatility as property.
