1 The path to retirement success How important are your investment and spending strategies?
2 In this VIEW, Towers Watson Australia managing director ANDREW BOAL reports on investing for retirement success and the important role of your spending strategy. Summary For a given amount of retirement savings, one of the most significant factors that will impact a person s financial success in retirement will be their chosen spending strategy. A low spending strategy will allow people to retain maximum flexibility in early retirement and then lock in a more sustainable and reliable income stream, that provides for at least their basic retirement needs, for the remainder of their lives. But another important question still remains: how should they invest their retirement savings? The answer to this question will vary depending on many factors, such as how much superannuation they have, how they intend to spend it, the amount of any other savings, as well as their risk tolerance and preferences. To summarise: It is quite apparent that one of the biggest factors that will determine a person s ability to achieve retirement success is how much they spend each year When combined with a low spending strategy, there is little difference in the likelihood of their savings lasting to age 90 for a conservative versus a balanced investment portfolio. But the residual balance left over at age 90 is likely to be much higher for a balanced investment portfolio gd The level of spending for a 90 year old is expected to be around 10% lower than for a 70 year old, which provides a good opportunity for a retiree approaching age 80 (say) to purchase some form of guaranteed annuity or other longevity risk pooling vehicle An adaptive spending strategy is also likely to further improve the chance of success in retirement For low account balance members with a short-term spending strategy such as five years, any advantage gained by adopting a more aggressive investment strategy is relatively small and may not be worth the additional risk taken on. When designing default retirement income solutions, superannuation funds first need to understand the demographics and expectations of the members they are targeting. The funds also need to help their members to understand more about their own expected retirement outcomes and the risks they face, by providing tools such as written retirement income estimates and online calculators. Only then will funds be able to guide their members more effectively into retirement income solutions that better suit their needs. 2 View November 2014
3 Introduction In their paper 1 released in July this year, Nick Callil and Jeff Chee considered the mission of an Australian superannuation fund. Here are some of the key findings: A superannuation fund s mission should be defined as the delivery of reasonable retirement expectations in a reliable fashion Those expectations should be based on the level of retirement income, rather than the accumulation of a lump sum Members should be made aware of their potential retirement outcomes, including the likelihood of success and/or the potential shortfall relative to their retirement targets. In this context, a person s retirement outcomes must combine the level of retirement income (which may vary over time) and the number of years it is paid (which of course is highly variable due to the uncertainty of their longevity). Retirement success If you put yourself in the shoes of a retiree, some key goals that spring to mind when considering their retirement income would include: Adequate I want to be able to live a reasonable life in retirement, similar to what I have become accustomed to Flexible I want to be able to meet unexpected expenses as and when they happen, without incurring significant penalties to access my money Reliable I want to be confident in the income produced by my savings so I can plan my spending with a reasonable degree of certainty and not have to make sacrifices from one year to the next Sustainable I don t want to run out of money before I die, or be unable to pay for the essentials of life. For most people, retirement will require a portfolio approach, assembling a variety of products to meet their different retirement goals, and also to match their own individual circumstances and personal preferences. The Age Pension is also likely to play a significant role for most people, at some point in their retirement. For most people, retirement will require a portfolio approach, assembling a variety of products to meet their different retirement goals, and also to match their own individual circumstances and personal preferences. Retirement risks When thinking about the retirement challenge, there are four main risks that retirees face (see Table 1). Table 1: Four main retirement risks Income risk Liquidity risk Investment risk Longevity risk Primarily the risk of income not keeping pace with inflation, but also taking into account variable spending patterns which may arise during retirement. The risk of not having ready access to capital when it is needed, without incurring significant penalties. The uncertainty and volatility of investment returns and, in particular, a sequence of poor returns around retirement age. The risk of running out of money due to living longer than expected, which includes the uncertainty each individual faces as well as the systemic risk arising from general improvements in population longevity. The least understood of these risks, and perhaps the greatest risk of all of them, is longevity risk. However, all the risks are interdependent and impact the others to varying degrees. In this paper we will focus on investing for retirement success, but we can t do this without at least some consideration of the other risks. 1 Rethinking the Superannuation Fund Mission: A member-focused approach. View November
4 A case study Let s start by looking at a sample couple. Why a couple? Well, according to Treasury, Census data in 2007 showed that over 70% of Australians enter retirement as part of a couple. To keep it simple, let s examine a couple who are both exactly age 65 and are retiring today 2 with combined superannuation assets of $500,000 to use for income generation (that is, after they have paid off any residual debt, used some more capital on once-off expenditure and set aside some cash for emergencies). The first question we need to ask is: How long should we try and make their savings last? Based on the most recent published Australian life tables, a 65 year old male is expected (on average) to live to age 83.5 and a female to age However, since the early 1970s, mortality rates for the over 65s have been improving steadily. Allowing for this improvement to continue, a current 65 year old male would instead be expected to live an additional 3.5 years to age 87.0, and a female 2.9 more years to age Using these improved life tables, there is a 72% chance that at least one of them will be alive at age 90. Let s now use the Towers Watson Retirement Planner to examine the impact of different investment strategies for this couple who want to make their savings last 25 years to age 90 (and assuming income is needed to support both of them to age 90). For this comparison, we ll vary the couple s exposure to growth assets 3 from 0% (cash) to 30% (conservative) to 50% (moderate) to 70% (balanced) to 85% (growth) to 100% (high growth). Investing in a balanced portfolio, the couple is expected to be able to spend $57,705 a year (including Age Pension amounts that are available after applying the means tests) up to age 90. After that, they re expected to rely solely on the Age Pension. But it is important to recognise that this is only the expected outcome. There is still only a 48% chance that their superannuation will last until age a higher exposure to growth assets does increase the couple s level of income in retirement without materially increasing the risk of running out of money before age 90. Figure 1: Impact of investment option on expected retirement income Retirement income per annum (today s dollar) $59,000 $58,000 $57,000 $56,000 $55,000 $54,000 $53,000 $52,000 $51,000 $50,000 $49,000 49% 49% 48% 48% 47% 47% $52,244 $55,803 $56,965 $57,705 $58,254 $58,417 Cash Conservative Moderate Balanced Growth High Growth Investment option in retirement As Figure 1 shows, a higher exposure to growth assets does increase the couple s expected level of income 4 in retirement without materially increasing the risk of running out of money before age 90. But what if we looked at this from a different perspective? After all, would retirees seriously consider a spending and investment strategy that only had around a 50% chance of success? Instead, let s take a look at the impact of different spending strategies for two of the more common investment strategies, being the conservative and balanced portfolios. Figure 2 shows that, if they adopt lower spending strategies (that is, $50,000 and $52,000 a year), there is a high likelihood of success (more than 80%) for both the conservative and balanced options. Alternatively, if the couple spend at higher levels (such as $54,000 to $58,000 a year) then the investment option chosen has a more significant impact on the outcome. For example, under a balanced investment option, spending $54,000 a year has a 67% likelihood of success, compared to 56% under a conservative investment option. Figure 2: Impact of spending strategy and investment option on likelihood of super lasting to age 90 Likelihood of super lasting to age % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 93% 89% 82% 81% 67% 56% 55% 38% 44% 24% $50,000 pa $52,000 pa $54,000 pa $56,000 pa $58,000 pa Investment option in retirement Conservative Balanced 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Likelihood of super lasting to age 90 2 We have used the new means testing rules that will apply from 1 January For this purpose, we have assumed that the diversified portfolios do not contain any unlisted assets. 4 The expected level of income in retirement is shown in today s dollars and is indexed in line with AWOTE (to keep pace with improvements in community living standards). 4 View November 2014
5 Spending strategy Let s now examine more closely the critical importance of the spending level in retirement combined with different investment strategies. Specifically, we look at the impact of spending $50,000 a year in retirement and alternatively $58,000 a year across a range of different investment options. In our view, it is unlikely that many couples with $500,000 at retirement would choose to spend $58,000 a year and accept only a 44% chance that their savings will last until age 90 if they invested in a balanced option or, even worse, a 24% chance if they invested in a conservative option (see Figure 3). It is quite apparent that one of the biggest factors that will determine a person s ability to achieve retirement success is how much they spend each year. So, let s now think about this problem another way....one of the biggest factors that will determine a person s ability to achieve retirement success is how much they spend each year. A more realistic strategy for this couple might be to choose a lower spending strategy that has a higher likelihood of their savings lasting to age 90. If, instead, this couple decided to adopt a low spending strategy of say $50,000 a year, then there is an 89% chance that their superannuation savings will last to age 90 if they choose to invest in a balanced portfolio, or a 93% chance if they choose to invest in a conservative portfolio. Both of these seem to be more favourable strategies for the retired couple, who could also consider spending $52,000 a year (with an 81% chance of success for balanced and 82% for conservative). Figure 3: $58,000 pa spending strategy residual balance and likelihood of super lasting to age 90 Residual balance at ago 90 ($) 900, , , , , , , , , % 24% 36% 44% 47% 49% Cash Conservative Moderate Balanced Growth High Growth Investment option in retirement Median 50% - 75% 75% - 95% Likelihood of super lasting to 90 While individual risk preferences will determine the couple s ultimate spending strategy, for the remainder of this View we have used the $50,000 pa spending strategy. In this scenario, there is little difference in the likelihood of their savings lasting to age 90. However, the amount of residual superannuation that is expected at age 90 will be significantly different depending on how the superannuation was invested. As Figure 4 shows, the residual balances at age 90 are quite similar for the different investment options in the event of relatively poor investment outcomes (the 5 th to 25 th percentiles). But the median outcome for the balanced option of $177, 372 is higher than the median outcome for the conservative option of $139,512, and the upside potential for the balanced option is also much higher. Figure 4: $50,000 pa spending strategy residual balance and likelihood of super lasting to age 90 Residual balance at ago 90 ($) 900, , , , , , , , , % $48,692 93% 92% $139,512 89% 87% 85% $164,622 $177,372 $185,169 $186,542 Cash Conservative Moderate Balanced Growth High Growth Investment option in retirement 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Likelihood of super lasting to age 90 Likelihood of super lasting to age 90 5% - 25% 25% - 50% 50% - 75% 75% - 95% Median Likelihood of super lasting to 90 View November
6 Variable spending needs Research suggests that a retiree s spending is likely to start reducing by around age 80. For example, if you consider the ASFA Retirement Standard (which is based on budgets for a retiree aged 70), the comfortable index includes a range of leisure activities including overseas travel. Removing a lot, but not all, of these activities would reduce spending by up to 20%. On the other hand, later in life, spending may increase to cover the higher expected costs of health and aged care. In this context, ASFA recently completed a new study which analysed the spending requirements of Australia s older cohort of retirees (more specifically those in their late 80s to early 90s). Whereas the current ASFA Retirement Standard is based on budgets that were developed for retirees aged 70, the revised ASFA report explores the spending requirements for retirees aged 90. While a full copy of the report is available on ASFA s website, the report s key findings can be summarised as follows: 1. An increasing number of Australians will live to age 90 and beyond 2. Older retirees tend to face increased costs related to care and support arrangements, and medical expenses 3. Older retirees have reduced expenditure on transport and on entertainment 4. These various adjustments taken together result in slightly lower expenditure for older retirees as opposed to those aged The Age Pension alone will not deliver a comfortable standard of living to older retirees. In particular, the comfortable level expenditures for 90 year old retirees are about 10% lower than for retirees aged 65-80, while the differences are much smaller for the modest level (see Table 2). Not only will the retired couple be starting to spend less, as they approach age 80 they are now more likely to have a better understanding of longevity risk and more fully appreciate the risk of running out of money should they live into their 90s. This would be a good time for them to consider insuring at least part of their spending needs for later in life. Their reduced spending on other activities would also be a good source of capital to pay premiums for some form of guaranteed annuity or other longevity risk pooling vehicle. The savings from this reduced spending could be kept aside and accumulated to pay the premium as a capital sum, or the premiums could be paid as regular instalments if the product permits. For our sample couple, staying invested in growth assets produces a better outcome than de-risking, either gradually via a lifecycle or target date fund or more suddenly. As we have demonstrated, a more conservative spending strategy will dramatically increase the likelihood of retirement success. For our sample couple, staying invested in growth assets produces a better outcome than de-risking, either gradually via a lifecycle or target date fund or more suddenly. In practice, retirees who stay invested in a higher proportion of growth assets are likely to adopt an adaptive spending strategy should circumstances warrant it. For example, if their superannuation savings experience a year or two of low or negative returns, they are likely to choose to spend less and defer some discretionary spending until the markets recover. Table 2: ASFA Retirement Standard (Q2 2014) Total spend per year Modest lifestyle single Modest lifestyle couple Comfortable lifestyle single Comfortable lifestyle couple 70 year old $23,363 $33,664 $42,433 $58, year old $22,529 $33,604 $37,665 $52,866 Percentage difference 3.6% 0.2% 11.2% 9.1% 6 View November 2014
7 Low account balances The sample case study we have looked at in this View is based on a couple with combined savings of $500,000. If, on the other hand, the retired couple only has $100,000 then the financial outcomes can look quite different. If this low balance couple wanted to have a similar standard of living in retirement, but for a shorter period before relying solely on the Age Pension, then this amount of superannuation would be likely to only last to around age 70. If this low balance couple adopted a spending strategy of say $52,000 pa (including the Age Pension of course), the likelihood of success (that is, their savings lasting to age 70) can be increased from 53% to 83% for a balanced portfolio, and from 55% to 94% for a conservative portfolio. This shows that if the spending timeframe is relatively short, then there can be advantages in adopting a more conservative investment strategy....if the spending timeframe is relatively short, then there can be advantages in adopting a more conservative investment strategy. For our original sample couple with $500,000 that is planned to be spent over 25 years to age 90, the increase in expected retirement income by investing in a balanced portfolio compared to a conservative portfolio is $1,902 pa (an increase of 3.4% from $55,803 pa to $57,705 pa). Whereas, for our low balance couple with only $100,000 that is planned to be spent over five years to age 70, the same increase is only $380 pa (an increase of only 0.7% from $54,150 pa to $54,530 pa) remember, these amounts allow for the means tested Age Pension and only have around a 50% likelihood of success. For this low balance couple, any advantage gained by adopting a more aggressive investment strategy is relatively small and is unlikely to be worth the additional risk taken on, due mainly to the short time period over which the money is invested. View November
8 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 15,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at. Contact For further information please contact: Andrew Boal Or your Towers Watson Consultant or Actuary: Melbourne Sydney The information in this publication is general information only and does not take into account your particular objectives, financial circumstances or needs. It is not personal advice. You should consider obtaining professional advice about your particular circumstances before making any financial or investment decisions based on the information contained in this document. Towers Watson Australia Pty Ltd (ABN , AFSL ) Copyright 2014 Towers Watson. All rights reserved. /towerswatson