Retirement boomers

Paul Resnik

Baby boomers are both living longer and tending to finish full-time employment earlier than previous generations.

Traditional retirement savings are often insufficient to meet our spending expectations. And because we have been forced to individually take responsibility for our retirement, we are being driven to optimise the asset pool that will fund our spending in our later years.

In addition, we cannot simply assume that funding to life expectancy will be sufficient. If we are in reasonable health and with good genes we may need to fund for 10 to 15 years beyond life expectancy. This leads to the inescapable conclusion that funding long-term care has to be a key component of financial planning.

We can ill afford to hold lazy assets, be they our home or our superannuation. It is hardly coincidental that developments in home equity release products parallel enhancements to investment performance available through second generation managed funds such as separately managed accounts (SMA). Both are tracking the same goal: highly personalised financial planning.

Planning with a financial dimension

For all of its avowed complexity, financial planning is a relatively simple concept. It starts with cash flow management.

Generally speaking, the more cash you hold onto, the better off financially you become.

The proposition a planner puts to a prospective client needs to run like this:

‘In the pursuit of your current and future goals that have a financial dimension, you must work on four interrelated goals. I will help you articulate, prioritise and meet those goals.

1. In the accumulation phase you can partially guarantee your personal exertion income and protect against major personal expenses and losses through life insurances. In addition, you always need to think about protecting your physical assets and third party liabilities through general insurances. This is a cash cost.

2. You need to spend less than you earn to create and maintain a savings pool.

3. If invested well, you can expect your savings pool (which for most Australian families must now include the family home) to grow at a rate of between 1 and 6 per cent per annum over inflation in the longer term, depending on the riskiness of the portfolio(s).

4. All financial plans have some level of financial risk. If the financial risk needed to achieve your goals is inconsistent with your risk tolerance, you must specifically accept that risk.’

Clearly, there are a number of trade-offs in play here. How should they be managed? This raises an even more important question as to how the trade-offs should be illuminated so that the client has a better chance of understanding the consequences of the alternatives available to them.

The best way for me to explain what I mean is through a practical example that will illustrate my argument.

Mike and Fammy are, at least on the surface, an affluent couple. In their early 50s, they have a significant investment portfolio of close to $2 million. They also have solid spending aspirations.

If they spend and earn as they would hope and wish, their investment assets would see them leave an investment estate of approximately $400,000 plus any residual value in their family home in their early 90s.

In 2040 they intend to sell the family home, valued presently at $850,000 (projected to grow at 1 per cent per annum real), and move to long-term care needing $800,000 (present value) for an accommodation bond. They intend to invest the balance of the sale price into a managed fund. They also plan to give an early inheritance to their children of $1 million a few years later (see screen grab).

The first of the trade-offs is the necessity, in their accumulation phase, to protect Mike’s income. Without his contributions the plan will fail. In the life plan we show the consequence of Mike’s immediate death.

By the time Fammy is 56, if she does not significantly alter her family’s lifestyle spending, she will be totally reliant on social security, and any income she can earn from her labour or selling the family home. The family is underinsured to the tune of $2 million. At Mike’s age the premiums would not be insignificant. The cost would either result in lower spending now or lower accumulated savings later (see graph 1 Money Mangement Magazine April 19, 2007 page 23).

In the continuing life plan (graph 2 see Money Mangement Magazine April 19, 2007 page 23), we illustrate the impact of one of the other trade-offs. The dark blue is the projected family balance sheet for Mike and Fammy as they spend to satisfy their goals. The investment return they will need to achieve this is 4 per cent per annum over inflation (after average fees but before tax) prior to retirement and 4 per cent per annum in retirement.

The red balance sheet shows the money running out at age 90. In this case this is a projection based on the growth and defensive asset allocation consistent with the member of the couple with the lowest risk tolerance (return target of 2 per cent per annum over inflation). Clearly, there is a substantial gap between the outcomes generated by the two return targets. Which is the right asset allocation for Mike and Fammy?

Mike and Fammy can achieve their goals within their risk preference by making a few lifestyle changes and a simple portfolio decision. Mike will need to work for two years beyond his planned retirement at 60, and they will need to spend $7,000 per annum less on living costs in retirement. In addition they intend to run their money more efficiently.

When clients have significant amounts of money invested, one of the major impediments to goal achievement is the cost of investment.

SMAs provide a simple away of delivering additional return with no increase in risk. By removing the inefficiencies inherent in traditional managed funds a planner should be able to deliver the benefits of professional funds management at a better price. This includes avoiding potential double taxation in unrealised capital gains, decreasing the number of transactions, reducing transaction costs, diminishing tax inefficiencies and lowering portfolio implementation leakage.

There is a professional view in the market, when all else is equal, that a well-managed SMA should be able to deliver an extra 1 per cent per annum with the same asset allocation as a traditional portfolio made of up of unit trusts. If this is correct, it means Mike and Fammy can invest through an asset allocation consistent with their risk tolerance. Combining working longer, spending less and investing more efficiently makes their original goal achievement attainable.

Proofs of a defensible planning process

The challenge is to personalise the client’s planning experience. By using lifestyle or goals-based planning to help them better understand how their present and future lifestyle will be influenced by either or both of their spending and saving and the returns they earn we can achieve that goal.

The objective is to help baby boomer clients take control and responsibility for their financial future and to give them the ability to change their financial behaviour in pursuit of their own goals.

Graphical personalised planning supports good compliance

Clients need the ability to test their key trade-offs and immediately see the consequences. They walk away with a written road map of their financial future, reinforced by numbers and strong graphics they can understand.

Choices include clearly articulated lifestyle trade-offs not just investments. Critically, clients will have the tools to make informed decisions and take responsibility for the outcomes within their control.

In order to justify decisions made and the contract agreed with the client, the planner must demonstrate the rigor of the planning process adopted.

What does this mean for the funding of longer term obligations such as an accommodation bond?

It is dawning on many that the family home has to be included as a financial asset. This leads to a wider purview for planning than simply Financial Services Reform Act assets. Planners must be able to accommodate all the client’s assets in their financial planning.

This would include a clear articulation to the client that the family home may need to be included as a financial asset to release equity to fund their lifestyle, sometimes sooner and sometimes later.

It will also mean that there needs to be a transparent illustration of the alternatives in play such that clients can move to making a ‘properly informed commitment’ to the plan. This will necessarily involve communication that delivers messages in words, pictures and numbers to better match the client’s preferred learning style.

Mike and Fammy are typical successful baby boomers who have a financial road map, it accounts for most of what is broadly predictable about their future. It will no doubt diverge from reality and it may well need to be significantly rewritten several times over the next 30 years. That is the point of planning.

It is the ongoing conversations with the Mikes and Fammys of this world that make planning so valuable.

Paul Resnik is a baby boomer, a financial services industry consultant and commentator. He has interests in a number of tools designed to help financial planning businesses run more successfully. He can be contacted at [email protected].