Layered approach to retirement
The phrase "outcomes-based" has become a mantra within the retirement planning industry in the years since the global financial crisis (GFC), and reminded us that risk and return are positively correlated.
Although it is seven years since the onset of the GFC, 80 per cent of retirees still deem it important that their savings are not adversely impacted by short-term market falls.
Nearly 40 per cent of retirees state they could not tolerate any loss in their retirement savings over one year1, according to research conducted by National Seniors Association and Challenger.
Most recently, the Financial System Inquiry's (FSI) proposition for a comprehensive income product for retirement (CIPR) seeks to establish outcomes-based planning as the default approach to investing in retirement. It cites over-reliance on balanced account-based pensions as posing unacceptable risk to retirees.
At the same time, we have seen the rising popularity of longer-term outcomes-based, income-layered strategies.
Unlike other strategies whose acceptance and usage may wax and wane with the markets, income-layering has consistent appeal and offers a key and distinctive advantage for financial advisers; it requires little explanation and makes clear sense to clients.
There is no financial jargon for clients to understand, as is required when talking in terms of diversified portfolios, asset allocation or even the aptly named ‘bucket approach'.
Income-layering in retirement picks up where a pay-cheque left off, engendering trust and a sense of control, predictability and security for clients about their future.
But the rapid uptake of outcomes-based planning is not just being driven by its common sense appeal to risk-averse retirees. It has a sound theoretical rationale.
An outcomes-based approach will evaluate a range of potential outcomes in planning to meet retirement goals and will be based on clients' needs.
Retirement is different
Effective retirement planning acknowledges that saving for retirement and spending in retirement require different approaches, and client needs and risks are different (see Figure 1).
Challenger research identified that retirees' highest priorities2 are:
- Health — can I afford aged care and medical expenses?
- Longevity — will my income last as long as me?
- Peace of mind — will income cover all essential expenses?
- Inflation — is the income inflation adjusted?
It also identified thematic risks:
- Market — what assurance is there my savings won't be eroded by the market?
- Inflation — how will inflation undermine the purchasing power of my savings?
- Political/regulatory — will unforeseen changes undermine my anticipated retirement plans?
- Sequencing — how does the order of negative returns affect my savings?
The impact of sequencing risk
Sequencing risk, a subset of market risk, is amplified in retirement.
The underlying issue of sequencing risk is that money lost is harder to gain back.
If a client's investments fall and rise by 10 per cent, it is natural to assume that the client's portfolio would be even, but this isn't the case. The investor actually needs a higher return to offset any losses (see Figure 2).
Long-term data on the Australian market indicates that it can take between six to 10 years for equity markets to recover from large market crashes3.
Retired clients are the most vulnerable to sequencing risk for three reasons.
First, retirees have their largest ever sum of savings, so in a market downturn, they have the most to lose.
Second, since retirees are no longer contributing to retirement savings, recouping losses is almost impossible.
Third, because retirees are drawing down income, any market correction will deplete savings faster.
Retirement phases
Retirement has multiple stages, each with differing expectations and income needs to be taken into consideration.
The first stage is generally a period when retirees are active and healthy and want to spend some of their savings on travel, leisure and entertainment.
For retirees it is also a period of larger retirement savings so while income is important in this phase, so is the need to mitigate market risk.
The next phase is the passive stage where spending needs begin to decline.
The third phase of retirement may involve a new transition such as moving into residential aged care. This is generally a time where retirees are frail and experience health issues.
Where to start
An income layering approach is a growing trend amongst advisers that enables clients to lock in a bedrock income, while permitting growth access (see Graph 1).
The fundamental building block for any retirement plan is to assess what eligibility to the Age Pension a client has.
Around 80 per cent4 of retirees are eligible to at least a part Age Pension, so this forms the base level of retirement income.
While the Age Pension is the premium retirement product, it is not substantial enough on its own.
To meet a retiree's essential expenses, clients can layer the Age Pension with a private pension like a lifetime annuity.
A lifetime annuity has similar features to the Age Pension. It provides a known, regular payment for life, is indexed to inflation and is sheltered from market forces.
Once expenses have been met with the first two layers, clients can use the final layer for growth.
The benefit of income layering is that because clients' essential needs are already covered through the Age Pension and an annuity in the first two layers, they are liberated to take on a robust investment strategy to achieve their wants through an account-based pension in the top layer.
While a client's retirement strategy will vary depending on their risk appetite, it should be built on an outcomes-based approach led by a client's goals.
John Carnevale is the general manager, advice services at Challenger.
FOOTNOTES
1 NSA & Challenger, March 2013, ‘Retirees' needs and their (In)tolerance for risk'
2 National Seniors Australia & Challenger, ‘Retirees needs and their (in)tolerance for risk'
3 Challenger, ‘The ABC of sequencing risk'
4 Deloitte, ‘Dynamics of the Australian Superannuation System The next 20 years: 2013—2033'
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