Advisers hear this question from clients constantly. The answer depends not only on life expectancy, health and demographic characteristics, but also personal preferences for spending, desired lifestyle and legacy objectives.
Guiding client conversations away from a specific big number needed for the future and towards the concept of "financial security" gives you the opportunity to learn about clients' retirement goals and explain the steps needed to attain them.
For most people, saving for retirement begins when they get their first job and their employer starts contributing to super. How tempting it can be to do nothing more than rely on an employer to contribute 9.5% of their ordinary earnings for retirement use. However, many academic studies show that employer super guarantee contributions alone won't provide most individuals with sufficient income in retirement.
How can advisers persuade clients to save more through super when they have priorities besides retirement, such as building up a cash deposit for their first home or saving for their children's higher education?
You may want to acknowledge that saving for retirement may not seem an urgent priority. But you'd do well to emphasise how a long investment time horizon can work in the client's favour.
These four steps, subdivided into simple tasks, can help you outline a course of action for clients still earning a paycheque:
There's no universal formula for creating an "optimal" plan for retirement, but constructing such a plan is nevertheless essential.
As clients near retirement, advisers can help them prioritise goals, evaluate risks and understand how long their money might last.
As clients near retirement, the choices they face can be overwhelming, leaving many unsure of where to begin. Given the strong possibility for a 25-year or even 30-year retirement, many investors risk being underprepared.
Advisers can walk clients through Vanguard's retirement planning frameworkopens new window, which gives retirees the opportunity to develop a personalised roadmap toward financial security:
The orange chart below shows the resources that best align with each of the four goals identified above. The maroon chart shows the risks each resource mitigates.
Note: "Relative effectiveness" is a measure of how well the resource either supports a goal or mitigates a risk.
Age is a powerful filter for investment decision-making. Many advisers say that if they had to build a financial plan based only on one piece of information that age would be that critical data point.
The life-cycle approach to retirement investing takes the inertia frequently associated with young investors – who often aren't focused on saving for retirement and don't make decisions to do so – and turns it into a positive force. But life-cycle investing can make sense for investors of all ages.
When it comes to saving for retirement, investors can choose from an array of investment options covering the major investment categories: cash, fixed interest, property, life cycle, diversified balanced, Australian and international shares. Since 2013, super funds have
Life-cycle investments are "all-in-one" funds that are designed to help investors simplify the way they manage their portfolios and reduce their investment risk. These funds address sequencing risk by moving investors from growth investments to more defensive investments as they approach retirement, and the portfolio is automatically rebalanced.
The life-cycle default option for super maintains an allocation of about 75% to assets, including equities, property and alternative investments, until members reach age 55. Then the life-cycle option begins to become more conservative.
Your clients possess various stores of capital throughout their lifetimes. Younger workers have an abundance of "human capital," or the net present value of future expected wages. They haven't accumulated substantial assets, but their 30- to 40-plus years of future wages can be treated as an asset, with risk characteristics similar to that of a bond portfolio. The future stream of wages (or "coupons") represents nearly certain cash flows.
So the younger worker can embrace risk – and its greater potential reward – with their financial assets through a high allocation to stocks. Should a market downturn dent their retirement assets, the investor has ample time to recover.
Your older clients are more likely to have accumulated assets, or "financial capital," on which they'll need to depend in retirement. So their risk profile tilts away from the growth associated with a high allocation to shares and towards preservation of capital.
The downward slope of the illustration's human capital line mimics the de-risking that occurs within a life-cycle fund. A life-cycle fund gradually reduces its exposure to equities (correspondingly increasing its fixed income exposure) as the aging worker "spends" their human capital.
The key challenge in portfolio construction is to find the asset mix that strikes the right balance between investment risks and expected rewards through retirement. Advisers have seen firsthand what can happen when clients are left to allocate their own assets. Some invest 100% in equities. Others include no equities whatsoever in their portfolios. Even those investors who create a balanced asset mix can fail to rebalance their portfolios over time as their life circumstances and the markets change.
Life-cycle funds help address such errors. They provide a diversified portfolio option as a single investment choice or default investment, preventing investment at the no-equity or all-equity extremes. And they delegate rebalancing to the portfolio manager, thus creating a positive force out of investor inertia.
If life-cycle investments form the core of retirement portfolios, advisers can focus on other aspects of clients' lives.
Once clients are engaged with super either through voluntary salary sacrifice or after-tax non-concessional contributions, why might it be prudent to limit their choices?
Superannuation funds have been adding more asset classes, and some members embrace the challenge and responsibility of self-directed investing. But real-world data from the super system should give advisers pause about the effect of choice on investor outcomes.
Default settings and member inertia are important elements of the Australian system, especially during the early accumulation phase. But, over the course of their working lives and into retirement, super fund members have a wide range of choices and incentives for additional discretionary transactions available to them, over and above the mandated Superannuation Guarantee contributions and default product selections.
Depending on the particular super fund's rules and procedures, members can generally allocate their portfolios across multiple investment options, switch between them at any time, and provide different portfolio allocations for future contributions. Members can also elect to retain accounts in multiple funds (for example, leaving a balance in one fund to take advantage of higher group insurance benefits, while allocating ongoing contributions to a different APRA-regulated fund or SMSF).
What's the relationship between member choice and investment outcomes? Vanguard's How Australia Saves 2017 reportopens new window examined member-level experiences over five years ending June 2016.
The scatterplots show the dispersal of outcomes for three main groups of investors: those in the default life-cycle option, those who selected from a list of diversified balanced options, and those who built their own portfolios.
The majority of investors who remained in the default life-cycle option enjoyed very uniform outcomes with an extremely tight risk/return distribution and returns of 8.4% per annum in a well-diversified portfolio with regular rebalancing and automatic adjustments to more conservative investments for members aged 55 and over.
Members who made their own selection from a shortlist of diversified balanced options experienced a broader dispersion of outcomes that reflected their individually selected risk/return profiles.
And self-directed investors experienced the widest dispersal of outcomes – while some members appear to have achieved pretty good results, many did not … and very few actually outperformed the 'do nothing' life-cycle default.
The data highlight the risks facing your clients in a defined contribution system like Australia's – the ability to make short-sighted or impulsive investment selections or switching decisions that might end up costing them.
The answer is not to abolish the idea of member-directed investment choices, as they play a valid role in tailoring investment strategies, especially for members using advice.
Keeping choices within some constraints might be a good strategy, both commercially and in members' interests by protecting them from themselves. While adjusting the choice architecture of super funds is in the hands of their trustees, advisers can provide guidance to clients to help them make appropriate investment selections.
Investors cannot control the markets, but they can often control what they pay to invest. And that can make a difference when saving for a retirement that may last two decades or longer.
Advisers can raise client awareness of the importance of minimizing cost. After all, when it comes to investing, the lower their costs, the greater their share of an investment's return, and the greater the potential impact of compounding.
In a low-interest, low-growth investment environment, investors have an even greater motivation to minimise investment costs. Every dollar saved in costs is an extra dollar to invest.
For example, say a client makes a onetime investment of $10,000 in two funds. Both funds have a 6% average annual return, but Fund A has a 1% expense ratio and Fund B has a 0.30% expense ratio. In ten years, the balance in Fund A would be $16,196 and the balance in Fund B would be $17,378. That's a difference of more than $1,000, attributable entirely to investment expenses.
The long time horizon associated with saving for retirement should prompt advisers and their clients to pay attention to how high costs and fees erode portfolios both inside and outside the superannuation system.
Clients pay a variety of fees as a member of a superannuation fund:
The Productivity Commission said members pay more than $30 billion a year in fees, excluding insurance premiums. The administration and investment costs incurred by superannuation funds are some of the highest among the private pension systems of developed nations measured as a percentage of total investment by the Organisation of Economic Co-operation and Development.
Clients who've established Self-Managed Super Funds face additional costs. Initial set-up costs include the preparation of a trust deed by a solicitor as well as professional advices for the trustees. Annual ongoing costs include the supervisory levy by the Australian Tax Office (ATO); accountancy fees to prepare financial accounts; audit fees; fees for the preparation and lodgement of annual tax returns; tax advice; and brokerage fees for transactions.
The ATO reported total annual costs for the average SMSF member rose to $7,200 in 2016 from $5,300 in 2013. Separately, the Productivity Commissionopens new window noted that while some SMSFs expand quickly and perform well, others appear to start small and stay small. About 42% of all SMSFs have been under $500 000 in size for at least two years, and those smaller funds tend to experience high average cost ratios and low average returns.
Advisers can help clients understand the costs and risks involved in setting up and running an SMSF. Does it make more sense to establish an SMSF or to choose an existing super fund? Advisers can frame that decision in the context of their clients' individual circumstances.
While superannuation garners much of the attention when it comes to retirement, about half of all personal investments can be found outside the super system.
Non-super investments are expected to become even more important to higher income super members as well as retirees with large super balances.
Australian investors tend to have a significant concentration toward property. Self-managed super fund (SMSF) portfolios tend to include a 15%–20% exposure to property. Outside of super, property is the biggest investment for many clients.
Since the early 1990s, Australia has experienced a prolonged period of economic expansion, with property prices supported by falling interest rates and increasing leverage. That raises an issue that advisers should discuss with clients: The amount of property debt they are carrying. Average property debt has increased from $78,400 in 2003–2004 to $149,600 in 2015–2016, according to the most recent figures from the Australian Bureau of Statistics' Survey of Income and Housing.opens new window
Compared with other developed economies, Australia stands out for the high debt burden households currently carry. The International Monetary Fund opens new window calculated that household debt to GDP was 122% in Australia in 2017, compared with 78% in the United States, 86% in the United Kingdom and 100% in Canada.
Where retirees in previous generations expended a small amount of their income on housing expenses in retirement, future retirees may find they'll need to spend more to pay their mortgage and other debts.
Beyond property, your clients likely hold other investments outside super. Consultant Rice Warner calculates that the value of non-super personal investments ($2.8 trillion ) overtook super assets ($2.3 trillion) during 2016–17. The Vanguard /Investment Trends 2018 SMSF Report found that a third of SMSF trustees are making, or intending to make, investments outside super.
Driving that growth are changes to the super system, including the lowering of contribution caps and the introduction of a $1.6 million pension transfer cap as at 1 July 2017. These changes have advisers and clients focusing on non-super assets such as:
A key difference between super and non-super investments is tax treatment. Investors with more of their assets outside concessionally taxed super have an added motivation to make their portfolios as tax efficient as possible.
When clients have multiple financial resources, advisers can play a key role in helping investors coordinate their super and non-super portfolios. Such guidance will demonstrate your value when it's time for a client to begin drawing down their assets in retirement.