When planning for retirement, you may be prompted to think about how your super is invested. Choosing an appropriate investment strategy for your super, will necessarily involve consideration of risks. Although risks can often be managed or minimised, it’s important to understand they can’t be eliminated entirely.
For those who are approaching retirement, or are already retired, some key risks to be aware of include investment risk, inflation risk and longevity risk.
Understanding these risks and how they can impact your retirement savings is essential.
If you’re working with a financial adviser, we recommend discussing these risks with them before making any investment decisions. By engaging in open discussions with your adviser and focusing on a strategy tailored to your needs, you can navigate these challenges more effectively.
Investment risk
Investment risk, or volatility, is about how much the value of your investments might go up and down over time. Generally, investments that have higher potential returns come with a higher level of risk, whereas investments that offer lower returns generally come with less risk.
Market risk
Market risk, a key component of investment risk, reflects the potential fluctuations in the value of your investments, whether you’re investing in shares directly, or through a managed fund. These fluctuations are influenced by a range of factors, including shifts in company profitability, industry trends, economic cycles, investor demand, business confidence, and the policies of governments and central banks.
Investing your super in a diversified portfolio can help to protect your savings against investment risk.
Sequencing risk
One lesser-known investment risk is sequencing risk, which concerns the timing of investment returns.
Sequencing risk arises when the returns on your investment are lower than expected, or negative, especially early on in your retirement journey when the investment value is typically largest. This risk becomes more pronounced if you need to withdraw funds from your portfolio when returns are negative, as the withdrawal further reduces the capital base in the portfolio. This means you need to achieve a higher return in future to put you back in the same capital position. It can have a significant impact on retirees, who may be relying on their investments for income, as it reduces the value of their retirement savings as well as potential future investment returns.
Example
Gerry, age 65, decides to use his super to start an account-based pension. His account-based pension has a starting balance of $600,000. To meet his living expenses in retirement, Gerry works out that he needs an annual income of $35,000 (in today’s dollars).
Gerry chooses to invest his super in a balanced portfolio, which targets an average long-term annual return of 6 per cent. However, the path of investment returns can be unpredictable, as illustrated by two potential scenarios that affect the longevity of Gerry’s super for at least the next 20 years, when he reaches his statistical life expectancy of age 85.
Scenario 1: Early retirement market downturn
In the second and third years of Gerry’s retirement, market prices fall, resulting in a -6 per cent annual return on his super, before recovering to an annual return of 6 per cent. Gerry maintains his withdrawal of $35,000 each year. In this scenario, his super is projected to support him until he reaches age 83, which is just short of his target of age 85. To get back on track, Gerry would need to earn a higher rate of return on his superannuation for it to last until he’s 85.Scenario 2: Mid-retirement market downturn
The same fall in market prices as in the example above occurs later in Gerry’s retirement. Initially, the return on his superannuation is 6 per cent per annum. However, for a 2-year period, when Gerry is around age 74-75, his superannuation experiences a -6 per cent annual return before recovering to 6 per cent per annum. Because Gerry’s account balance benefited from positive compounding returns for longer before market prices fell (compared to scenario 1), his long-term outcome is better in this scenario, as his super is projected to support him until he reaches age 85.
These scenarios underscore the importance of planning and flexibility in retirement strategies. Understanding how varying market conditions can impact superannuation over time allows for better preparation and adjustments to your retirement plan where needed.
The scenarios are calculated using the following assumptions:
pension payments are made annually at the start of each financial year
pension payments increase annually based on an inflation rate of 2.5 per cent
apart from the timing, the rates of return used are otherwise the same in each scenario
the results are expressed in today’s dollars based on an inflation rate of 2.5 per cent
all returns are assumed to be net of fees.
One way to help manage sequencing risk, is to use what is often referred to as a ‘bucket strategy’. This involves keeping a certain amount of savings in cash investments. For example, this could be the amount needed to cover living expenses for a few years. This reduces the risk that you may need to sell your investments during a market downturn.
As with market risk, ensuring your investments are diversified across a range of asset classes, geographies and industries can also help to manage sequencing risk.
Inflation risk
Understanding inflation is important, especially when planning for retirement. Essentially, inflation refers to the increase in prices of the goods and services that households typically buy – it’s commonly measured by the Consumer Price Index (CPI). The Reserve Bank of Australia aims to maintain the CPI growth between 2 and 3 per cent annually. However, in recent years, the Australian economy has experienced higher rates of inflation. In the year to December 20231, inflation resulted in the living costs for self-funded retirees rising by 4.0 per cent. Retirees reliant on the age pension saw their living expenses increase by 4.4 per cent over the same period.2
Inflation risk is the risk that the purchasing power of your income may fall over time. As prices rise, you may not be able to buy as much with your income in the future as you can now. This risk is an important consideration for retirees who are typically on a fixed income and may also be reliant on their savings, as they may find it challenging to sustain their desired lifestyle in retirement.
Example
Erica, age 70, has living expenses of $35,000 a year and uses her super to start an account-based pension to meet these expenses.
If inflation continues at a rate of 4 per cent per annum, in five years’ time Erica’s living expenses will have increased to $42,583 and she will need to increase her account-based pension drawdown to this amount to maintain her current standard of living.
Even at a lower level of inflation, Erica will still need to increase her pension payments to maintain her standard of living. For example, if inflation was 2.5 per cent per annum, in five years’ time Erica’s living expenses and pension drawdown will have increased to $39,599.
To help manage the risk of inflation, careful consideration should be given to how your retirement savings are invested. If inflation increases by more than the returns on your investments, this can impact your ability to maintain your lifestyle in retirement.
Longevity risk
The amount of time you spend in retirement will depend on when you choose to retire and how long you live. Given the unpredictable nature of life expectancy, there is a possibility that your retirement savings will not sustain you throughout retirement. This situation is called longevity risk.
When preparing for retirement, it’s common to plan based on an estimated lifespan, often using statistical life expectancy as a guide. For example, if you’re a male retiring at age 65 today, you might anticipate approximately 20 years in retirement, according to current life expectancy data. Likewise, if you’re a female retiring at the same age, you might plan for around 22 years in retirement. This means that your super (and other savings) potentially needs to last for more than 20 years. It’s important to remember that these are statistical averages and your actual life expectancy may be different. Additionally, as life expectancy averages have generally been increasing for some time, your life expectancy may also increase, increasing the risk of you outliving your savings.
Some options for managing longevity risk are considered below.
Guaranteed income through an annuity
An annuity, sometimes called a fixed term or lifetime pension, is a retirement income product designed to offer a guaranteed income for a fixed period or for your entire life. This provides a consistent cash flow, which helps manage some of the risk that you’ll outlive your retirement savings.
However, it’s important to note that once you’ve purchased an annuity with your retirement savings, you generally can’t access the funds, which means that you can’t make lump sum withdrawals. Additionally, the income you receive is generally fixed when the annuity starts and doesn’t change over time.
Diversifying your investments
A diversified portfolio of investments, including a mix of growth assets to help your savings grow over time, meaning that they support you for longer in retirement. This approach comes with its own challenges though, as your investments are not guaranteed to last for a particular timeframe.
Government support
The government age pension provides a safety net for retirees who outlive their retirement savings. The amount you receive depends on various factors, including your marital status, income and assets, and is designed to cover basic living costs.
Managing risks to your retirement income
Risk management is an important element in any retirement plan because it can significantly affect how much income you’ll have and how long your super will support you in retirement.
How you manage the risks associated with investments, inflation and longevity will depend on your circumstances.
A financial adviser can help you develop a strategy that is tailored to your needs.
