Understanding risk is perhaps the hardest aspect of finance. One risk that should never be forgotten is the risk of running out of money before you die.
The simple default balanced fund option is perhaps not the best for everyone, but tailoring a retirement strategy to suit your risk profile is not easy. Real life examples would include such aspects as taking a variable amount of pension depending upon market conditions, taking profits from equities in particularly good years and, as I wrote in an earlier column, having several different buckets (or funds) from which to draw your pension.
How much do you need?
There are many different combinations of cash and equities weightings that you can hold in a stock portfolio, but which will help you make your money last longer in retirement?
In my previous column I discussed the nature of historical data on capital gains and dividends for the S&P/ASX200. (You can re-fresh your memory by reading How to make your money last a lifetime [1] and Are equities really that scary [2].) I showed a risk analysis of alternative strategies of combing cash and equities based on that data and then compared that with how much the average person needs in retirement (according to the Association of Superannuation Funds of Australia’s (ASFA) balanced fund assumptions).
Let me repeat those basic assumptions. Inflation is assumed to be 3% per annum (pa), cash attracts 5% pa, the retiree couple has $850,000 and draws down $55,080 pa – after adjusting for inflation – to maintain an ‘ASFA – style’ comfortable existence.
Getting real
Based on the ASFA figures, assuming the superannuation is invested in a balanced fund that returns about 7% pa, the retirees on average will exhaust their fund after about 22 years and transfer to the old aged pension.
However, if we introduce risk into the experiment – assuming volatility of 7% pa, which is consistent with an APRA study using data from the late 90’s and early 2000’s – the picture looks quite different. There is then a one in 100 chance the fund is exhausted before 14.3 years, but a one in four chance it will last 29.4 years or more.
If I dial up the volatility to, say, 12% to be perhaps more relevant to the future, there is now a one in 100 chance the fund is exhausted before 11.1 years! A long way from the ‘headline’ 22 years in the typical ASFA example.
Since equities are typically much riskier than balanced funds, it doesn’t seem to be a wise move to fully invest in equities and draw down a pension. Using financial year data from 1985/6 to the present, I calculated the average capital gain was 5.9%, average total return (including dividends reinvested) was 12.1% and average total return including franking credits was 13.6%. The annualised volatility was 15.7%.
One million hypotheticals
Rather than do a simple simulation experiment, I performed a more advanced statistical method that samples from past data in blocks of varying length to create a variety of hypothetical futures. For example, the first draw might be returns from three consecutive years starting in 1987/88, the second might be a draw of four years starting in 2007/8, etc.
By joining up these histories into a string that lasts 50 years into the ‘future’, the first experiment starts with the 1987 crash and is followed straight after by the GFC, etc. I repeat this experiment one million times. Some of the million scenarios would be dreadful and some excellent, but most would be near the average that was actually experienced.
I assume the pension is taken at the beginning of each year so that $55,080 is drawn and the rest is in equities. The results are in the column headed ‘1’ (for one year’s worth of cash for the first pension payment) in the Table.
The average life expectancy of this equity fund (the median at 50% probability) is in excess of 50 years! Much better than for the balanced fund because the average return is much higher in equities. The downside is that there is a 1% (one in 100) chance the fund runs out before 10.1 years and a 10% (1 in 10) chance it runs out before 20.1 years.
The cash and equities balance
To compare performance of a different portfolio, I now start the experiment with five year’s worth of the assets in a cash fund at 5% pa and the rest in equities – drawing down first the cash before taking any from the equity fund. The results are in the column ‘5’. The fund lasts about one year longer for the 0.1% to 25% probabilities, which is not a lot of gain.
If I now take the fund up to 10 and then 15 years worth of cash, there is not a lot left in equities to grow while the cash is being drawn down. However, with 10 years in cash, the downside risk at one in 100 is 15.5 years and this is better than for the low-volatility balanced fund with an average of 39.2 years and a reasonable potential that there will be inheritance money for someone when the couple passes away!
Table: Longevity of a cash-equity fund running out
[3]Notes: For assumptions see text.
Ron Bewley is the executive director of Woodhall Investment Research [4].
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.
Also in the Switzer Super Report:
- Peter Switzer: Will the Europeans go for gold? [5]
- Paul Rickard: Caltex comes to the hybrid market [6]
- Charlie Aitken: Is Woodside headed back to $45? [7]
- Andrew Bloore: Don’t be tempted to lend to members [8]