Recently I read an article in Super Review magazine containing some superannuation projections. The actuarial firm of Rice Warner performed the calculations. What really grabbed my attention was the key economic assumptions:
“Net earnings of 6.25% in accumulation, 4% in pension
Wage inflation of 3.5% and CPI of 2.5%”
Whoa, I thought, hang on a minute, in accumulation phase, there is a 15% tax on earnings within the fund. But once the member is in pension phase, there is no tax on the earnings at all. Why would they assume lower earnings in pension phase than in accumulation? Have Michael Rice and Jeff Warner suddenly lost their marbles? But I know them both. Last time I spoke to them, each spoke very coherently, and there was no sign of madness. (Not to mention that Michael was recently announced as Actuary of the Year).
So why would Rice Warner assume much lower earnings in pension phase than in the accumulation phase? They are assuming much more conservative asset allocation once a fund member retires and commences a pension. That’s why the rate is so low in pension mode. That is why the assumed earnings rate reduces from 3.75% greater than CPI to only 1.5% greater than CPI. That is a big shift – a 2.25% reduction in the assumed earnings. And that is despite the fact that the change in the tax environment might have indicated an increase.
In making this assumption I am sure that they have taken into account typical asset allocation changes within superannuation funds. I do not question the appropriateness of what they have done. Many default super schemes are on a “lifecycle” basis where the allocation to growth assets markedly reduces from between ages (say) 45 and 65. I myself was a member of a corporate scheme where the default investment option reduced from 85% to 45% over a 20 year period, from a strongly growth-oriented asset allocation to a fairly conservative one.
But is a switch to a much lower allocation to growth assets right?
There are some reasons why it may be appropriate to adopt a more conservative investment allocation in retirement. For one thing, once you have retired, it may be difficult to take remedial action if there is a major collapse in equity values. When you are still working, you can consider deferring retirement so it makes sense that you can afford to take a little more risk. Also, typically financial advisers will only recommend investments in volatile asset classes such as shares and property where there are longer timeframes between the date of investment and the date when you will want to dispose of the investments for consumption purposes. As you approach retirement, your average time until you will need to dispose of assets to support your consumption expenditure decreases, so arguably the proportion of growth assets should reduce a little.
But there are many reasons why the allocation to growth assets should not be curtailed dramatically.
Reducing allocation to growth assets is targeting the wrong risk
Reducing the exposure of the portfolio to growth assets will reduce the volatility of the portfolio. But what is the volatility risk? What does it matter, in reality, that the market falls from 100 to 80? Often when that happens, the next thing is it rises back to 100 again. And often market values fall despite little or no reduction in dividends paid. Really the risk faced by the retiree is not the risk that the market value of their holdings will fall. It is the risk that their assets will run out before they pass away. Or the risk that other goals will not be achieved.
If your choice of investments is really intended to target accomplishment of your personal goals rather than some reduction in “volatility” then often it may turn out that the retiree needs to accept “volatility risk” in order to improve the chances that they will be able to meet their really significant goal, such as to maintain their required lifestyle for the duration of their life. That is the central result of my paper to the 2015 Actuaries Summit.
Investment timeframe is still long for many retirees
Although retirees need to start drawing income from their investments, their investments still need to last many years. For example, I’m 61 and retired from full time employment and my wife is…… oooppss, I’ve sworn to maintain secrecy. All I can say is that she is younger. But actuarially there is a good chance that at least one of us will still be around in 40 years time.
In my book Slow and Steady: 100 wealth building strategies for all ages, I calculate the sustainable withdrawal rate. The answers depend on the planned period of retirement and the real interest rate. A couple investing in growth assets and achieving a 5% real return can spend 5.7% of their initial assets every year (indexed for inflation) and their money will last for 40 years. A couple investing in a “stable” asset allocation with say 20% to 39% growth assets and achieving a 2% real investment return can only spend 3.6%. By taking more asset risk a couple with a 40 year life expectancy can increase their consumption expenditure by about half.
Often a retiree can draw down an appropriate amount from their pension without disposing of much of their invested capital. For example, for a retiree aged less than 65, the statutory minimum withdrawal rate is 4%. But the average dividend yield on the ASX200 recently has been about 4.2%. So a retiree can draw down at least the statutory minimum without any need to sell any shares.
Free investment insurance
For part pensioners whose pension amount is determined by the assets test, investment risk is cushioned by the increase in the age pension that will be payable if the investment turns out poorly. I made this point in more detail in my post “Free investment insurance! Part pensioners only need apply”.
Investing conservatively has its problems too
Finally, investing conservatively in cash and fixed interest investments has its own risks.
If you invest in cash, you have a problem when interest rates fall dramatically as they have since the GFC. Ten years ago, in October 2007, the cash rate was 6.5%. That might have been sufficient to allow a conservative investor to live off the bank interest. But today the RBA cash rate is 1.5% and the rate available on bank deposits has fallen correspondingly.
Another risk, if you invest in longer dated fixed interest securities, is inflation. That doesn’t seem like much of a risk now, with inflation at very low levels compared to history. But who can say for sure that the inflation dragon is dead, rather than just sleeping?
A retired investor may legitimately choose to adopt a more conservative asset allocation than when they were younger. Every retiree needs to make his or her own decision based on personal circumstances. But there are many reasons not to switch to an unduly conservative an asset allocation in retirement.