Retirees face a variety of risks in retirement including market risk, inflation risk and longevity risk. Here are some strategies to help mitigate them so you can achieve financial peace of mind.
Anyone with a healthy superannuation balance heading into retirement in February 2020 would have felt relatively confident that they were both mentally and financially ready for the next chapter in life. But fast forward a few weeks and that confidence might have been shaken somewhat as financial markets dipped into negative territory overnight.
Few forecasters could have foreseen the impact of COVID-19 and the rapid drop in markets, leaving most investors with losses that diminished almost a third of their investment portfolio. And without a regular pay check to contribute to an investment portfolio and make up for losses, retirement can indeed seem to be a risky business.
But it does not have to be so.
At Vanguard, we are very fond of reminding our investors to stay the course, particularly during a market downturn. And for good reason. While staying the course might sound like doing nothing to many, that actually isn't the case. On a practical level, staying the course means sticking to the investment plan that you put in place pre-retirement, and periodically re-evaluating your asset allocation to ensure that it is aligned to your goals, time horizon and risk appetite.
And while past performance is no guarantee of future results, hindsight has time and again taught us that those who moved to cash immediately after the March 2020 market crash then missed the subsequent rebound a month later. Investors might have experienced relief at having exited the market's volatile swings, but that temporary emotional reprieve would have locked in those paper losses and then barred the investor's portfolio from experiencing the ensuing market recovery, forfeiting the opportunity portfolio values to be restored.
At the time of writing this article, the ASX has well and truly recovered from last year's low and is currently breaking all-time records. But rather than resting on your laurels and assuming that everything is back to normal, now is the time to think about the risks that retirees (or those about to enter retirement) face and seek out strategies to mitigate them.
As a retiree without a regular income to help make up for capital losses, market volatility undoubtedly delivers a heavier punch. But this is where rethinking discretionary spending could help. While it isn't an ideal solution, in a situation where you can control neither the market nor what it returns, your spending is an aspect that you can control. Reducing your spending slightly in step with your reduced portfolio balance might help ease financial stress and help navigate through the crisis. Once markets settle then spending plans can be revisited.
With the prospect of rising interest rates on the horizon, inflation is a quite a hot topic in the financial news at the moment, but inflation risk is nothing new. Assuming that the cost of living increases by 3% year on year for the next 30 years, your expenses will double in that time frame. As such, planning for inflation as part of your investment strategy and using 'real returns' rather than 'nominal returns' when looking at investment returns is key.
As medical advancements and technology improves, so has our quality of life and life expectancy. The average Australian can now expect to live to their mid-eighties and if you're lucky, until 111 like Australia's oldest person, Dexter Kruger. Knowing this, factor in that if you retire at 67, your retirement savings may need to last you a minimum of 16 years and possibly up to 30 years and more. And to adjust your time horizon accordingly if you're retiring before you turn 67. Also, you should plan for the possibility of health issues as you age, and direct discretionary expenses previously allocated to hobbies and travelling towards healthcare expenses.
As mentioned earlier in the article, the best course of action during periods of market volatility is to tune out the noise of everyday headlines and staying the course. If the March 2020 volatility was too much for you to bear, perhaps your tolerance for market risk is not as high as you thought. Now would be a good time to reassess your risk tolerance and consider a tilt towards more defensive products such as bonds, to help protect your portfolio from the next inevitable dip.
And if doing this on your own sounds too hard, consider seeking out the advice of a financial adviser. The value of a good financial adviser is most evident during periods of market volatility and not solely because of your portfolio returns. The emotional support provided during a period of anxiety is invaluable and should not be measured purely in dollar terms.
Finally, with the prospect of low yields and muted returns for the foreseeable future, it can be tempting to allocate more of your investment portfolio to equities, in a bid to meet your spending needs. But consider that you will be greatly elevating your portfolio risk at what is probably the most conservative phase of your investment journey. Instead of tilting your portfolio towards value stocks, perhaps consider the use of a total returns approach instead of relying on dividends to deliver income.
2020 rewarded disciplined investors for remaining invested in the financial markets despite troubling headlines and a challenging environment. It would be prudent to maintain this discipline and long-term focus for the years ahead.
The total returns approach
The alternative to an income-oriented strategy is the total returns approach, where a portfolio's asset allocation is set at a level that can sustainably support the spending required to meet those goals and encourages the use of capital returns when necessary.
It is a strategy that looks at all sources of return from your portfolio, both income and capital –first assessing an individual or household's goals and risk tolerance, and then setting the asset allocation at a level that can sustainably support the spending required to meet those goals.
Unlike an income-oriented strategy which generally utilises returns as income and preserves capital, the total-return approach encourages the use of capital returns when necessary.
During periods where the income yield of a portfolio falls below an investor's spending needs, the capital value of the portfolio can be spent to make up the shortfall. As long as the total return drawn from the portfolio doesn't exceed the sustainable spending rate over the long term, this approach can smooth out spending during the volatile periods for markets which inevitably occur.
Of course it may also require the discipline to reinvest a portion of the income yield during periods where the income generated by the portfolio is higher than the sustainable spending rate.
It should be noted that while capital returns - best represented by the price movement of shares - can be a volatile component of this strategy, taking a long-term view is paramount.
An iteration of this article was first published in Your Life Choices in August 2021.