At any stage of life, clients seek an investment strategy that maximises their portfolio over a given period with as few surprises as possible. In a basic sense, finding the most suitable strategy for their needs can be called an investment problem. However, the investment problem in retirement differs meaningfully from the problems for which traditional products and strategies have been designed.
We note that a large number of customers use the same investment strategy after retirement as the one adopted in the accumulation phase of their lives. While this appears understandable given they have demonstrated a comfort with the level of volatility of their fund in accumulation, these strategies have not been designed with retirement, and its progressive withdrawal of cash flows, in mind.
We call this the retirement problem and there are a number of reasons why it is different to other types of investment problems. Here, we look at a few:
1. How long will I live?
The first, and perhaps, most critical part of the retirement problem is longevity. Retirees don’t know how long they’re going to live and, at retirement, they face a broad range of possibilities around life expectancy. However, in general, we know Australians live longer than they used to as a result of higher standards of health and improved medical care but, for many, retirement savings balances are modest.
2. How much can I spend?
Retirees also face the question of how to invest their financial assets and at what pace to withdraw cash from the account to fund their preferred lifestyle. We can think of their future spending goals as a liability on the household balance sheet at retirement, one which needs to be serviced by current financial assets and other sources of cash flow (e.g. social security or home-equity release).
Most retirees have some level of flexibility in their retirement spending so it is helpful to identify a sustainable spending rate early on. Perhaps on account of the challenge of determining a sustainable withdrawal rate, many retirees default to the age-based minimum withdrawal rate permitted for account-based pensions. On the other hand withdrawals can also be too small, in which case there is strong likelihood that the account will remain quite large even at their life expectancy or beyond. This means that the retiree didn’t enjoy the lifestyle that they could have afforded because they lacked confidence that the outcome would be favourable and spent too conservatively.
We believe there is scope to deliver a more stable cash flow experience.
3. What if I get it wrong?
In retirement, clients have effectively one chance to get it right and mistakes cost far more than when they do in the accumulation phase of life. In fact, a key role of financial advice is to help older workers understand whether they should remain in the workforce a bit longer or even improve their skills in preparation for a new role.
4. What do I do about risk?
Financial assets are largest near retirement so the greatest financial risk is early on. An unlucky run in markets combined with excessive withdrawal levels can compound, creating a devastating impact on retirement wellbeing. This suggests portfolios should be relatively more defensive at retirement or have a clear risk management strategy to underpin the delivery of a baseline cash flow requirement. Perhaps counterintuitively, as time progresses there may be scope to add equity exposure if the funding position for future cash flow has improved.
Regardless of the size of their account balance, retirees need products that adapt to investment conditions, providing some growth, even in the drawdown phase, with a focus on risk management strategies to minimise the prospect of running short of money in retirement.
In addition, it is often hard for retirees to maintain confidence in their retirement strategy when their account balance is declining and there is no clear line of sight between investment returns and sustainable cash flows.
Given this, we believe there is scope to significantly improve financial wellbeing in retirement by implementing strategies with a more transparent linkage to the spending goals of retirees and providing ongoing reporting to maintain confidence that the strategy is on track to meet their goals.
Most importantly, we believe that the starting point for any solution is a clear understanding of retirees’ goals and the relative priority attached to those goals. In doing so, clients may experience greater peace of mind and enhanced wellbeing in retirement.
We believe the retirement problem requires a new suite of investment strategies and products that fully leverage our access to assets and markets but are explicitly managed to achieve the goals of retirees. We are designing products with this strategy at the core; an approach we believe is more relevant to our clients’ financial wellbeing and successful retirement.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.