Goals-Based Investing

How to manage money differently in retirement - Part 2

By Darren Beesley
Sydney, Australia

As we discussed in Part 1 of this series, retirees require a different approach to money management and investment to those in the accumulation stage.

There are seven key strategies that are particularly vital in order to shift the focus from accumulation to a decumulation approach more suitable for retirees, and in this article, we consider the final four of these: increasing income exposure, tax awareness, inflation awareness and managing duration. 

4. Increasing income exposure

An income strategy can deliver significant benefits to retirees such as:

• Asset liability matching benefits – it makes intuitive sense that cash flow needs are met by assets that continually produce cash flow via dividends, coupon payments or rent. When cash flow in mostly covers cash flow out, investors have less need to sell the underlying investments to fund the required cash flow, which ultimately means less exposure to short term price volatility.

• Tax benefits – Australian equity income can deliver major tax benefits for retirees from franked dividends.

• Behavioural benefits – an income focus means investors aren’t as focused on the underlying volatility of their capital and they are more likely to stay the course during difficult markets, for as long as they are getting income, volatility doesn’t matter as much.

The current low-yield environment has forced many investors to chase income through high dividend-paying stocks, bonds and property. Some commentators argue that total return is all that matters. There is no doubt income investing can be overdone; what is needed is a balanced approach that invests in quality assets with resilient income streams and stable capital value.

Key principles to look for in fund managers that align to these needs include:

• The ability to deliver a stable income stream which grows in real terms and in line with rises in the cost of living,

• Investment in high quality companies with strong cash flows and capacity to sustain and grow dividends,

• Investment in a diversified portfolio likely to exhibit lower volatility than the broad market from a capital and income stream perspective,

• In the case of Australian equities, investment decisions being made in a tax-aware manner with the goal of maximising benefits from franking credits,

• The capability to selectively utilise options where appropriate to enhance income and improve income diversification by broadening the investment opportunity set beyond traditional high-yield sectors and

• Avoid the permanent loss of capital in the pursuit of income. 

5. Tax awareness

It’s understandable to think that retirees don’t have to worry about tax any more given they are no longer working. But by investing retirement savings in a more tax-aware manner, the result can be a
boost in income.

There is a growing awareness of the role that equities, and particularly dividends, can play in delivering retirement outcomes. Equities can help protect against inflation and longevity risk. And through dividends, equities generate a regular and reliable income that grows.

Franked dividends are extremely valuable to retirees. Franking credits – the tax credit investors can claim for tax already paid on an Australian company’s corporate earnings – became refundable in the early 2000s.

For retirees on a 0% tax rate, they receive an uplift of up to 43 cents on each dollar of fully franked dividend.

In the 10-year period of 2008-2017, the cumulative value of all franking credits was 16.1% for a passive Australian equities investment. This equates to an additional 1.5% per annum compounded for Australian equities1.

Additional after-tax value can be added in retirement via:

• An income focus within Australian equities,

• The underlying Australian equities process valuing franking credits and treating matters such as off-market buybacks through the lens of a zero-tax payer, and

• Portfolio construction adjustment to hold more physical exposure to Australian franked dividend paying stocks, and ‘transfer’ the market risk (using futures) to global equities to provide greater diversification. This can generate more franked income domestically and may reduce withholding tax offshore. 

6. Inflation awareness

For Australians in accumulation phase, inflation is not such a big threat because their salaries and contributions, as well as their expenses, are likely to be linked to inflation. But it’s a different story for retirees who don’t have inflation-linked ‘assets’ in terms of salary and future contributions. For retirees, an inflation spike means they would pay more for their basic living expenses, such as groceries and utilities and they would need higher future cash flows to meet those costs.

Yet many retirees are invested in conservative and moderately conservative funds which have a large exposure to government bonds and duration, which underperform when inflation spikes. (The longer the bond’s time to maturity (duration) the more it tends to fall when inflation accelerates).

In fact, to maintain the same real standard of living over a 30-year retirement, a 1% increase in inflation requires a 13% increase in retirement savings2. We believe many strategies currently offered to retirees fail to recognise this.

Retirement strategies should hold assets that work to hedge inflation risk. This includes inflation-linked bonds rather than nominal bonds and tilting toward sectors that have revenues linked to inflation such as infrastructure, property, energy and agriculture.

7. Manage duration

The final strategy to consider is managing duration.

Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates, expressed as a number of years. For example, if a bond has a duration of five years its price will rise about 5% if its yield drops by 1%, and its price will fall by about 5% if its yield rises by 1%.

As the objective of retirement savings is to meet the retirees’ future outflows and goals, it is essential to ascertain how the value of those outflows would be affected by changes in interest rates. On the other hand, the value of the assets (current holdings) in the investor’s portfolio would also be affected by a movement in interest rates.

To remove uncertainty around interest rates, a portfolio manager can choose to match the duration sensitivity of the assets with that of future consumption (liabilities); this is referred as Asset-Liability matching.

In the current environment of extremely low interest rates, retirement strategies face a trade-off between lowering duration to minimise capital losses that would be incurred on long-duration bonds as interest rates rise, with the need to hold longer duration bonds to match the interest rate risk of future consumption. Strategies focused only on delivering total return or beating a market index benchmark are not managing this risk trade-off and this once again highlights the need for investments in post-retirement to be tuned to the bespoke needs of the retiree.

Conclusion

During the dark days of the global financial crisis many advisers saw retirees panic and sell out of investments at the worst possible time. But even more concerning, they heard stories of retirees hoarding and scrimping. They were worried about the future. They had no confidence that the traditional accumulation fund strategies would meet their income needs, nor protect their hard-earned savings, particularly during periods of market stress.

If we consider the seven factors we’ve discussed in this two-part series, and deploy them in the right capacity, we can significantly improve outcomes for retirees and we will be more likely to have a generation of retirees who are confident in their investments, more likely to stay the course and confident enough to spend their hard earned savings to enjoy the best retirement they can afford.

1 Based on the relative performance of S&P/ASX 200 Franking Credit Adjusted Daily Total Return Tax-Exempt Index vs the normal S&P/ASX 200 Total Return Index.
2 The change in present value of flat real consumption over 30 years if inflation increased from 2.5% to 3.5% and the nominal expected return on assets is 6%. (Assumes no correlation of asset returns to inflation).
 

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  • Goals
  • Goals-Based Investing
  • Goals-Based Investing Update
  • Retirement

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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