Making sure your investment return projections add up
In order to meet clients’ changing demands, financial planners need to review their standard practices – especially with regards to return projections, writes Fiducian’s Merton Miles.
A major development in the planning process to provide retirement living costs has been the ability to roll accumulated superannuation funds to an allocated pension – now known as an account-based pension.
Development of this facility provided the ability to have a single investment from which a regular pension could be drawn at selected intervals, but which also allowed drawing of capital if required.
Most account-based pensions offer a range of investment options.
This allows planners to recommend a strategic asset allocation designed to provide the funds for a regular income drawing, and also the prospect of future capital growth.
By framing recommendations to align with the client’s projected life expectancy, the planned outcome is to provide income for this time period and also allow some regular drawing of capital to ensure that clients’ funds will provide for their needs during their lifetime.
Projections of future value are based on the expected returns from the asset allocation recommended.
These projections also provide the prospect that in some periods, the capital value may show a negative return.
Example
A male client aged 65 years at retirement has a nominated life expectancy of 18.54 years. At age 65 the minimum annual amount to be drawn from an account-based pension would be 5 per cent of the invested capital.
The minimum drawing requirement is increased with client’s age and when the client has achieved his life expectancy (at age 84) the minimum required for drawing has risen to 7 per cent.
This will increase to 9 per cent when the client is aged 85 years.
Based on a conservative risk profile an asset allocation could be: stable assets 65 per cent, growth assets 35 per cent and the long-term earning rate 5 -6 per cent per annum.
How sound is the ‘standard’ approach?
The strategy is soundly based but raises the question of how accurate and reliable are projections which are based on “probable” returns over an “estimated” period of time, particularly if the clients need predictable consistent returns to meet their living requirements.
Long-term projections to an estimated life expectancy, using assumed earning rates, tend to focus on a probable outcome without consideration of what may impact on the projections.
A strategic asset allocation is designed to cope with the variations in asset returns and values.
However, if the projected earnings in any year are less than the prescribed minimum pension drawings, capital is further reduced and a higher future return is necessary if projections are to be reached. If we use hindsight, many concerns can arise.
What can upset the projected outcomes?
In the past 18.54 years we have seen:
- Interest rates reduce from mid-teens (1994) to low single figures (2012);
- Australian share values have fluctuated between a reduction of 8.6 per cent (2002) to an increase of 27.9 per cent (2004) and then a reduction of 38.9 per cent (2008); and
- International shares fluctuations have ranged from an increase of 41.6 per cent (1997) to a reduction of 24.9 per cent (2008).
And since 2008, we have lived through the impact of the Global Financial Crisis (GFC).
Common practice
Client requirements in retirement are often met by investing superannuation benefits in an account-based pension.
An asset allocation is recommended to provide both income and a level of capital preservation or growth.
Impact of GFC
Many clients with account-based pensions have suffered major problems as a result of the GFC, including:
- Substantial reduction in the value of their funds;
- Reduced returns on their remaining capital; and
- An increased need to draw from their reduced capital to meet their living costs.
Is there a better way?
To manage the differing requirements of a client and to offer some protection from the vagaries of markets we need to consider a strategy for each requirement rather than an “overall” strategy. Examples in order of priority are:
Strategy 1 – Retain a cash reserve to meet ongoing costs.
Suitable investments for this strategy could be cash-at-call and short-term deposits providing regular maturity.
Strategy 2 – Select investments to provide a predictable level of income for a foreseeable time frame.
There is a developing trend to provide income requirements from term deposits spread over terms up to five years and this provides a strong level of predictability.
As interest rates fall however, maintaining the required level of returns becomes more difficult.
An alternative is to have some funds in quality shares which pay dividends with high levels of imputation credits.
Retirees paying little or no tax on their income have their returns increased from the refund of franking credits.
Strategy 3 – Select investments with potential to grow in value over life expectancy.
Funds not required for strategy 1 or strategy 2 can be diversified to match the client’s risk profile over their life expectancy.
By careful selection of investments, based on the outcome they are designed to provide, we can ensure predictable returns over nominated periods.
This is particularly acceptable to retirees and a focus on, say, a five-year period within the life expectancy cycle is realistic and provides a level of comfort to many retirees.
If the recommendations made initially are based on the client’s life expectancy with an inbuilt period of predictability, the advice can be adjusted at each review to continue the time frame of the predictable return period.
Adjustment can be made to the capital required for each strategy and any changes in clients’ circumstances or requirements.
Conclusion
Financial planning techniques and strategies have developed to meet our clients’ varying needs.
The GFC has highlighted the difficulties which can arise and to meet our clients’ current requirements may mean that we review or refine our standard practices.
Perhaps a “predictable return” cycle within life expectancy can increase the realisation of our projections.
Merton Miles is a financial planner at Fiducian Financial Services.
Recommended for you
The Compensation Scheme of Last Resort says it has received over 200 claims for compensation relating to personal financial advice since its inception and detailed the specific recurring issues being raised by claimants.
Two financial advisers have shared with Money Management why they opted to specialise in certain client niches when setting up their own business.
Insignia Financial has reached a major milestone in completing the separation of MLC Wealth from NAB, having acquired the firm back in 2021.
There could be changes ahead for how ASIC requires licensees to handle conflicts of interest as the corporate regulator announces it will be meeting key stakeholders next year to update guidance.
