Re-thinking The Retirement Risk Zone
Written by Kate McCallum, Multiforte
Are you within 15 years of retirement? Or have you recently retired?
If so, then according to Professor Michael Drew of Griffith Business School, you are in the 'retirement risk zone' - the time when you have the greatest amount of retirement assets in play, and subsequently have the highest level of risk.
We had the chance to chat with Professor Drew while at the advanced investment conference - and we share here key points from our discussion.
The retirement risk zone
If you are in this zone, you are probably feeling uncomfortable about your investments right now. You have just lived through a decade littered with extraordinary periods of investment risk: the dotcom bubble; sub-prime lending; the Global Financial Crisis; and now, the sovereign debt crisis.
You know better than others that investing for retirement is about taking risks. You understand that there is a fine line to taking a prudent amount of risk at every stage of our working and retirement lives. Too little risk and we will fall short of being able to live a fulfilling retirement lifestyle; too much risk and we end up with a depleted retirement nest-egg to the point we may never recover.
What are the risks, and how do you actively manage them?
So, what can you do to effectively achieve the 'right' level of risk and have the greatest chance of having the 'right' level of income in retirement?
We asked Professor Drew about his latest research - and new thinking on the risks individuals face as they plan for a comfortable retirement.
He sees three key risks that individuals in the retirement risk zone need to actively manage:
- The portfolio size effect
- Sequencing risk
- Longevity risk
The problem is that these risks are interdependent - you achieve little by managing any one without the others - and too few investors are aware of them, let alone having them under control.
Let's explore these concepts further.
The portfolio size effect describes the rapid growth of your retirement assets - due to the positive compounding effect of salary growth, contributions and returns - in the latter half of your working life.
Of course, to fund a comfortable retirement income, a large and rapidly growing portfolio size is exactly what you want. However, when the portfolio size effect is combined with an unfavourable sequence of returns, you can lose a lot of money.
Sequencing risk relates to how returns are obtained year in, year out. An investor who suffered from the Global Financial Crisis just a few years before retirement could end up with a retirement balance that is 30 per cent lower than that of a member who retired before the crisis.
"If you have a GFC-like event five years from your retirement, what does that do? It destroys something like 1.5 times your lifetime contributions to super and lowers the value of your likely retirement income by about 30 per cent," Professor Drew said.
Which is exactly what happened to many investors aged in their 50s and 60s with an exposure to growth assets like shares of 70 percent or more. These investors have borne the brunt of a decade of various financial crises and now are at risk of having inadequate funds.
The issue is they have limited, if any time to turn this around.
Issues of the portfolio size effect and sequencing risk then have a direct relationship to longevity risk. As we know, longevity risk is the likelihood that we run out of funds in retirement. If you were to have a smaller pool of retirement savings than you had planned, then by definition, your money will run out sooner.
In talking with Professor Drew we asked if sequencing risk is of concern for younger investors. His view was that for someone in their 20s, the impact of sequencing risk is minimal: because younger investors have typically have small account balances, and plenty of time to recover.
However, for someone aged 45-plus, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for themselves and their families.
3 key take-aways
Our key take-aways from our discussion with Professor Drew are:
- The retirement risk zone starts earlier than you think. You need to start actively managing your superannuation monies at least 15 years before retirement. So, if you are 45-plus, it's time to construct a superannuation portfolio that addresses the risks of portfolio size, sequencing and longevity now.
- Just one single, poorly-timed negative return event (of around -20%) can raise the probability of ruin from 33% to 50% for average life expectancy. Therefore, investors in this 20 to 25-year retirement time zone need to ensure they fine tune the level of risk to which their assets are exposed, and then need to continue to actively manage their asset allocation.
- If you are in a default fund or standard one-size-fits-all 'balanced' portfolio, chances are your asset mix is too risky. What's more, it is not adjusted for changes in market conditions, changes in your risk preferences, nor changes for your stage in the retirement risk zone.
