The 9 Risks to Retirement Income

Fundamentally there are four critical considerations when initiating or maintaining any investment. They are: What are the risk factors. What return has the investment generated historically. How available are the funds for withdrawal should circumstances change (liquidity) and what tax and fees are payable. Bank term deposits are favoured by many retirees because they tick all the boxes – or do they?

The assumption in this instance is that the retiree has money to invest in excess of the national pension. Financial advisors cannot assist retirees whom have lacked the foresight to plan for retirement or those who will not pay for professional advice due to cost, trust, DIY tendencies or free advice from friends and relatives.

The biggest hurdle facing the newly retired is management of cash flow in the ‘new’ environment. A life without earned income. For many this is hugely stressful, no matter the level of their financial resources. In most circumstances couples have managed their lifestyle through the allocation of income into living expenses. What’s left over has gone to savings. When the income stops this system of financial control falls to pieces and one of either two things happens. The retiree stops spending and life becomes a stressful financial balancing act (the frugal approach based on ‘Presbyterian’ scripting) or the retiree goes on living the life of ‘Riley’ and very soon the capital is depleted.

Step One: Take professional advice and plan for retirement pre and post cessation of earned income from work. Where one partner is left (that normally being the partner less likely to have been directly involved in either generating the greater level of income or maintaining the investment accumulation strategy) – taking professional advice is even more important because emotion can exacerbate susceptibility to bad advice (especially from friends and family). Action: pay for professional advice.

Step Two: Align the investment with an expenditure budget. In other words – the investment income becomes the replacement of work income. A $40,000 draw down from example is a 4% draw down of $1,000,000 investment. When added to a dual national super of $20,000+ - this example  couple has a net income after tax of $60,000 and their capital is not likely to deplete if it is invested within a diversified equity mutual fund. Action: determine a draw down facility which aligns with a pre determined expenditure budget.

Step Three: Differentiate market volatility from risk of loss of capital. Market jargon and media reporting link volatility with the word risk. Investment professionals measure ‘risk’ through a measure called standard deviation – the likely certainty of return performance over given time frames. For example the average temperature in Singapore is likely 30⁰ + and variability is minimal. The average temperature in Christchurch is likely 19⁰ but the variability is much greater – from a minus in winter to 30⁰ + in summer. The average is 19⁰ but the volatility is greater. Investments work the same way. One of the critical purposes in paying for professional advice surrounds this important investment principle. Markets are volatile but that does not mean loss but often it takes experienced advice, trust and service to prevent investors crystallising losses through volatility fatigue – transferring growth assets into cash.

Its application is another matter – why suffer the volatility at all. Because if we want a certain lifestyle i.e. $60,000 per annum, we want the investment to last our lifetime. If we invest in term deposits and draw down $40,000 per annum (plus receive the national super) we will deplete the capital very quickly due to tax, inflation and the size of the draw down. Action: Understand the difference between volatility and risk of loss. Its common – about every 5 years.

Step Four: We often compare our life expectancy to our family history of longevity. This could be seriously flawed – either way. Unless one’s lifestyle habits are extremely risky considering most recent lifetime averages would be advised. A married couple age 60+ means one of the partners has over a 50% chance of living past age 90. 30 years in retirement is a long time and medical advances these days mean that lifestyle in the 90’s is more likely to be like those in their 70’s today. Action: consider products like annuities and equities because outliving your income could truly be a ‘death by a thousand cuts’

Step Five: Inflation has averaged 3% since the 1920’s. Whilst it is at record lows at the moment, that certainly was not the case in the 1970’s when double digit interest rates and inflation were experienced. At 3% inflation (the average) cost of living increases by 80% over 20 years and 149% over 30 years. Any investor who ignores inflation will inevitably pay through depletion of capital or depletion of living standard. We might add that retirees are most affected by inflation because critical areas of their basic living requirements are subjected to above average price increases – areas such as medical, transport, power, food and housing. Action: Inflation risk must be factored in to a retirement plan.

Step Six: Lack of liquidity is a potential risk for retirees because they have lost the capability to borrow. Most pre retirees when faced with an emergency or ‘opportunity’ can use a multitude of ‘credit’ offerings. From personal loans, to overdraft facilities, revolving credit and credit cards. Things change a bit when incomes stop. The lender becomes less generous and the borrower more aware – aware of budget, aware of capital, aware of cost. Investments therefore that are lacking in liquidity may disadvantage. Action: Life has the inevitability to throwing in the unexpected therefore having investments with liquidity or liquidity being outside the base investment (cash reserves) is sensible.

Step Seven: Health costs and health care accommodation costs will escalate in NZ. There are four options. 1. Ignore them 2. Avoid them as much as possible through lifestyle choices 3. Manage the risk (personal cash reserves) 4. Offset the risk through insurance and estate management.

It would be wise to structure 3 and 4 because life’s surprises are often unexplained. Action: offset risk

Step Eight: There is an interesting shift in perspective that occurs when people retire. Early in retirement people don’t seem to have a desire to leave anything behind to their kids and grandkids. (apart perhaps from the family house). Their focus is more on their own lifestyle. However, as they get into their mid 70’s and 80’s the focus changes. They are less concerned about their own lifestyle and have a desire to leave something to the next generation. Action: plan for this eventuality earlier rather than later and consider how assets are preserved through generations.

Step Nine: Tax and fees worry retirees -  a. unless the retiree has been in business or personally responsible for making payments to consultants or professional advisers such as: financial planners, accountants, lawyers – paying for advice is a new phenomenon and one in which a cost benefit analysis becomes a headache or b. either a cultural bias or a DIY wiring can seriously retard the evolution of synergy and interdependence due to the stubborn retention of scripted attitudes. Action: both tax and fees are important considerations – never an issue for people with no money or investments. Accountants and financial advisers are simply measured and easily changed. If they are effective your costs are well worth it in value – if you don’t like them or you feel the cost exceeds the benefit – change the adviser, but do your due diligence. These days investment platforms allow for greater transparency of both tax and fees. When produced annually in conjunction with performance reports the combination of service, value, cost, risk, return, liquidity is easily measured and monitored. Make it an annual review process – the good advisers will not object to performance review – after all that is what you are paying for. Open communication and good service – positive outcomes usually accompany those attributes.

Summary

The financial knowledge and habits of most NZ’s is not growing to the extent that their incomes are increasing or their capital assets are accumulating. At the dawn of the new millennium we saw the result of this through poor diversification (tech stock crash),  poor asset class choice (finance company crash) and global financial crisis (availability of credit and lack of cash reserves). As the baby boomers begin the drift and then the eventual avalanche into retirement (see health care costs, long term care costs accommodation costs) there becomes a greater need for professional advice and strategic retirement planning. This needs to be addressed sooner rather than later and should be aligned with professional assistance from legal and accounting services