Allaying clients’ biggest financial fear: running out of money

Most of us dream of living to a ripe old age but with life expectancies continuing to rise, this is also affecting many clients’ confidence about how well they will fare financially in retirement.

One of the biggest worries for people after they retire is running out of money. In fact, a recent study undertaken by Challenger and National Seniors Australia has found that 53% of Australians over the age of 50 are worried about outliving their savings.  

A key reason for this fear is the increase we are seeing in life expectancies, which have risen by around two years over the past two decades. Once Australian women have reached the age of 65, they can now expect to live for another 22.3 years (to the age of 87.3) while the current life expectancy for Australian men at age 65 is currently 19.7 years (to the age of 84.7). 

As Australians are living longer, they are now spending a longer amount of time in retirement compared to previous generations. However, the size of nest eggs that retirees have to fund this period in retirement has not increased proportionately. 

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HELPING CLIENTS TO PREPARE

One of the key values that a financial adviser brings to a client is the intimate knowledge of a client’s circumstances and situation, along with insights into their preferences and tolerances. There are a number of ways that an adviser can work with their clients to best address the risk of an individual running out of money before they die. These strategies range from behaviours which can be adjusted in the lead up to retirement through to investment strategies which can be incorporated within portfolios post retirement.

Advisers can work with their clients on a range of behaviours that can be adjusted in the lead up to and following retirement. This can include a focus on reducing spending habits in order to save more, working for a longer period of time or continuing to work, perhaps on a casual or consulting basis after retiring from full-time work.

Many retirees who own their family home are asset rich as a result of the phenomenal growth in Australian residential property prices over the past decade. At the same time, these investors may have insufficient capital accumulated in their superannuation funds to meet their income requirements through retirement. One option which may be appropriate for these clients could be to sell the family home and contribute up to $300,000 of unlocked equity value to their superannuation.

STRATEGIES IN RETIREMENT

When considering a client’s investment portfolio in the period following retirement, a financial adviser may wish to consider whether an allocation to a guaranteed annuity product is appropriate for a client in order to help address longevity risk. 

Lifetime annuity products provide a guaranteed level of income for a client, backed by the issuing life insurance company. Those offered today offer far greater flexibility than those historically available with clients having the ability to access capital, if required, with lower penalties and flexible deferral periods available before the commencement of income payments, which can help in meeting an individual’s bespoke circumstances.

In order to make their nest egg last as long as possible, retirees need to ensure that they have enough of their portfolio invested in growth assets. Many investors increase their exposure to conservative asset classes such as bonds and cash as they approach retirement, however there is a fine balance between the need to protect the asset base and ensuring that the portfolio can generate adequate returns. By maintaining a healthy exposure to riskier assets with larger expected returns, the accumulated savings will likely last for a longer period of time as returns continue to compound, even as the retiree starts to draw down an income stream.

Longer lifespans mean today’s retirees need sound strategies in place to mitigate the risk of outliving their savings. However, with the right financial plan in place, clients can enjoy their retirement years with the knowledge that their finances are secure for the next 20, 30 or even 40 years.

WHAT IS SEQUENCING RISK?

One of the biggest worries for people as they enter the retirement phase of their lives is sequencing risk. Sequencing risk is the risk to the capital value of a client’s accumulated superannuation savings resulting from a sharp fall in the value of their portfolio early in retirement. 

As clients move towards the end of their working life and in the early years of retirement, their accumulated superannuation account balance is at its largest and as a result is more exposed to the risk of capital loss due to negative market movements. This risk is magnified in retirement as investors withdraw money as a pension to fund their living expenses, which may result in them locking in losses as they sell out of assets following a price decline. As retirees are no longer making contributions to their accumulated savings, they will find it very difficult to recover the decline in capital. The order and timing of investment returns is critical and two portfolios earning the same average return over a period, with differing levels of volatility can result in vastly different outcomes for an investor. 

The chart below illustrates how sequencing risk can affect a portfolio in retirement. A starting balance of $545,000 at age 67 has been assumed, with annual withdrawals of $27,646 made. The outcomes of two investment portfolios have been modelled: both have returned an average of 6% p.a. over the period, Portfolio A has a higher level of volatility than Portfolio B. The sequence of returns was very different for the two portfolios, Portfolio A suffered severe drawdowns in years 1-3, which Portfolio B avoided.

By year 13, Portfolio B had an account balance of $366,295, which was $295,043 higher than Portfolio A.

HOW CAN SEQUENCING RISK BE ADDRESSED?

It was easy for investors to be complacent about portfolio construction when the Australian stockmarket was into its second decade of a bull run as we rang in the new year just a few short months ago. However, now that we’ve officially plunged into bear market territory at the fastest pace in history, (a bear market is defined as a 20% decline from the recent high) the importance of constructing well diversified portfolios appropriate for clients’ requirements, life stages 
and preferences has been brought to light.

The importance of diversification across asset classes cannot be emphasised enough. The low correlation between different asset classes and the expected deviation in their performance under different market conditions and economic scenarios is one of the most effective strategies to managing the volatility of portfolios and creating a smoother ride for clients. Alternative assets typically have a very low correlation to traditional asset classes such as equities and bonds and the inclusion of alternatives in clients’ portfolios is always recommended.

Despite the recent volatility and correction in equity markets, we do not recommend allocating capital away from growth assets and into cash. It is extremely difficult to time the market and taking this type of action may cost portfolios dearly over the long run. Instead of attempting to make tactical changes to asset allocation, we recommend including allocations in clients’ portfolios to strategies with a specific focus on downside protection and capital preservation in order to address sequencing risk.

Equity investment strategies with a distinct focus on providing downside protection can be incorporated into a portfolio in order to reduce the sequencing risk facing those approaching or entering retirement. Investment managers for these strategies can generate a favourable upside downside capture ratio through the implementation of a number of investment philosophies and process including: seeking to invest in securities with low volatility and/or high quality characteristics or through managing portfolios with less than 100% net exposure to the equity market. A reduction is net exposure can be achieved through active allocation between cash and equities or through shorting securities as well as holding long equity positions.

When equity markets tumble, as we’ve experienced in recent weeks, strategies providing “hard protection” can be utilised in order to provide greater certainty around clients’ portfolio outcomes. These types of strategies offer guaranteed maximum losses (known as ‘floors’) when markets fall, with the guarantee backed by the balance sheet of the issuing life insurance company. In order to provide the guaranteed certainty to investors on the downside, participation in the upside of a rising market may be capped at a pre-determined level. Historically, these types of capital guaranteed products have been expensive and inflexible for clients, however recently more contemporary products have been launched at an attractive price point. An allocation to these products, alongside traditional multi-manager portfolios, should be considered for clients with a heightened sensitivity to drawdown risk as a result of their life stage or level of loss aversion. 

Miriam Herold is head of research at Centrepoint Alliance.