How SMSFs can reduce their longevity and sequencing risk

By AMP Capital

As SMSF trustees approach retirement, it’s essential you plan for two key risks: longevity and sequencing risk.

Longevity risk

Longevity risk is the risk you’ll outlive your retirement savings. This is one of the really big fears that investors face and, somewhat ironically, it can often lead people to invest too conservatively, which actually increases the longevity risk of their portfolio.

A case study

Troy is nearing retirement and wanted to understand whether the amount he has in superannuation and other investments would outlast him or would run out before he died. If it ran out then he may end up relying on friends and relatives for support in addition to any social security benefits to which he would qualify.

To work this out, he first had to make some estimations as to how long he may live. Would he live a normal lifetime into his 80s, longer than that into his 90s, or maybe even until he's 100? Most of his close family had lived to their late 80s and a few into their 90s. To see how long his retirement money would last, he did some estimates based on average fund returns for a balanced superannuation fund.

He found that if he had $1.3 million in superannuation when he was 65, earned an average rate on his remaining superannuation balance each year of about 7%, drew a pension commencing at $80,000 indexed to inflation of 3% annually, his superannuation would last him until he was about 93.  This sounded pretty good as it would last him well past an average life expectancy of about 85 years.

However, what would happen if he needed more than that to live on?  He found that on the same assumptions if he needed $100,000 indexed at 3% annually, then the money would run out when he was about 85. If he needed $120,000 indexed at 3% annually the cupboard would be bare at age 81 which was not the result he was looking for.

Troy was also concerned that the rate of return on his superannuation balance would not be regular each year and if he needed more money than expected then it may run out quicker than what he estimated.

Ways to reduce longevity risk

The uncertainty that Troy may run out of retirement savings is known as longevity risk. There are a few options for trustees looking to reduce the level of this risk.  These could be to reduce the amount to live on, diversify the retirement savings investment portfolio, increase the amount being saved for retirement, or purchase a lifetime pension or annuity which could commence at the time the amount accumulated for retirement is expected to run out.

Sequencing risk

Sequencing risk is the risk of an investment performing poorly at precisely the wrong time. For example, if a person entering retirement suffers a dramatic loss, the portfolio may not have enough time to recover even if the market does eventually rebound.

A case study

By the time Brad was 55, he had accumulated $400,000 in superannuation in a balanced portfolio.  He was satisfied with the performance of his fund and by the time he had reached retirement at 65, his super balance was just over $1.3 million.  He wondered if the result would be any different if the returns on his superannuation balance occurred in a different order while in the accumulation phase, so he reversed the order in which his superannuation balance accumulated income and found the result was the same. He even mixed these earning rates up just to see what happened and still came up with the same result.  Here are the earnings rates of Brad’s superannuation from 2007 to 2017:

Case Study Graph 1

*Annual rate of return on a balanced superannuation fund as published by the Association of Superannuation Funds of Australia (ASFA)

Brad then thought about starting a pension when he was 65 and whether there would be the same pattern if the pension was to last until he was 85. He used rates of return for a balanced superannuation fund to see what would happen. In some years there were good returns and in others, there were not so good returns.  Brad found that the result was very different to what had happened in the accumulation phase.

Brad found that the amount accumulated at 65 of just over $1.3 million, less the pension payments to age 85, would provide him with a balance at 85 of about $1.5 million.  However, if the order of the returns were reversed Brad ended up with a larger balance at 85 of about $1.9 million.  This assumed that he would be drawing the minimum pension under the rules each year (ranging from 5% of the pension account balance at age 65 and rising to 9% of the pension account balance at age 85). The earnings rates that Brad used for his superannuation between 65 and 85 were:

Case Study Graph 2

Ways to reduce sequencing risk

What Brad was observing here was what is called ‘sequencing risk’ which is the impact of the order in which rates of return are earned on a person’s balance.  Here we are considering Brad’s superannuation balance as he draws a pension when he has retired.  However, the same would occur if Brad had personal investments and required some money to live on.

Sequencing risk can be moderated by diversification of investments to reduce the level of volatility, adding amounts to the balance such as making contributions to superannuation in Brad’s situation or changing asset allocation. Greater diversification of investments may result in a more conservative portfolio with lower returns but a greater certainty that those returns will be obtained.

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Important notes

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.

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