18 November 2020
New approach needed for desperate income investors
Outdated portfolio thinking has left millions of Australian retirees vulnerable to low interest rates and higher sharemarket volatility, argues Allianz Retire+ .
As interest rates worldwide plumb record lows, retirees are taking on more risk to earn enough investment income to live on – a strategy that could permanently damage their wealth.
“The latest rate cut is another blow for retirees” says Allianz Retire+ CEO Matt Rady. “Some retirees are investing in shares to earn higher yield – and are left wide open to high market risk. Another financial shock could be financially catastrophic for them.”
In November, the Reserve Bank of Australia (RBA) reduced the official cash rate to 10 basis points, from 25 basis points. Retirees who have most of their savings in cash and bank term-deposits are barely earning a positive return on their money after inflation.[i] In addition, retirees continue to face comparatively high deeming rates, suggesting that many may be going backwards by way of being means tested on income they simply cannot achieve in this environment.
In Australian shares[ii] , RBA analysis[iii] shows the average dividend yield was about 4.5 per cent in 2019 (from 6-7 per cent in previous years). Yields are likely to be lower this year because of dividend cuts and cancellations during the Coronavirus pandemic.
“Retirees are being forced up the ‘risk curve’ in the search for yield,” says Rady. “They are in a no-win situation. Returns from cash and bonds are too low to fund a dignified retirement. And high sharemarket volatility can damage their financial and physical wellbeing.”
Retirees let down
Rady says retirees need innovative tools to navigate the “new normal” of ultra-low rates that the RBA expects to persist for at least three years[iv] . “Traditional portfolio-construction approaches for retirees are becoming increasingly less effective. What worked in the past in retirement investing isn’t cutting it today. ”
There are two main flaws with current portfolio approaches for retirees, says Rady. The first is using “volatility” to define risk. “Most retirees don’t care about volatility or standard deviations. Their greatest risk is running out of money during retirement” he says.
With Lonsec Investment Consulting, Allianz Retire+ challenged the appropriate measure of risk for retirees – an approach it calls the ‘Retirement Frontier’. “For years, retirees have been told to hold more defensive assets (bonds, cash) and fewer growth assets (equities) as they age,” says Rady.
”But that theory is now blown out of the water because it consigns them to low returns and a higher risk of running out of money.”
The second flaw is an inadequate response to share market volatility. Portfolios must contend with almost six times as much volatility to generate the same returns as 20 years ago, according to Callan Associates research[v].
“Retirees have to hold a lot more growth assets to generate the same return as previous years,” says Rady. “But that exposes their portfolio to much higher return uncertainty at a time in their life when they have less capacity to recover from financial setbacks.”
Higher volatility also increases sequencing risk – the order and timing of returns – for retirees.
“Those nearing or just in retirement, who held more shares for yield, watched the value of their shares tumble in March as the pandemic erupted,” says Rady. “Sadly, some will never fully recover those losses because their portfolio was in the wrong place at the wrong time.”
Heightened loss-aversion is another factor. Research shows retirees feel the pain of a loss ten times more than joy of a gain[vi].
“Allianz Retire+ surveys[vii] show many retirees worry about potential losses on their share investments,” says Rady. “Many are ‘self-insuring’ against the risks of running out of money by living frugally, or they reluctantly draw down on their money. It shouldn’t be like that: retirees should be able to invest in the sharemarket with confidence and enjoy their retirement.”
Rady says financial advisers should look to protect retiree capital in the sharemarket. “As retirees hold more growth assets, protected equity strategies must be embedded within portfolios, to better manage volatility and all the problems it creates.”
Rady understands why some advisers have shunned protected style equity linked products in the past. “Historically, products with a protection element have been costly, requiring investors to sacrifice too much upside, or have been offered by product issuers that are not well known.”
Breakthrough retirement investment solution
Rady says that it’s a new breed of retirement product that can provide retirees with a greater degree of certainty, while specifically addressing the features retirees are seeking in their investments.
“We are seeing a lot of progressive advisers use our equity linked product with inbuilt protection to gain exposure to higher yield from Australian and Global shares, while minimising downside risk of uncertainty for their retiree clients. We think it’s an attractive proposition: exposure to growth with inbuilt protection, at the cost of 85 basis points per year. That’s less than the cost of most managed funds.”
Investors are able to gain market-linked exposure to Australian and International Equities or a fixed rate. They then choose between three types of protection, depending on the level of losses with which they are comfortable. The three protections (Floors) are -10%, -5% or 0%. Each Floor has a corresponding “Cap” – the maximum gain investors can enjoy in one year. The lower the Floor, the higher the Cap.
Rady comments that retirees are still able to draw a regular income stream and adjust their investment and protection options annually – across the product term - based on changing lifestyle needs or market conditions.
For example, in any one year, a retiree could choose a -5% Floor on Australian equities. The most they could lose from their investment in a year at that Floor is 5 per cent. The most they could gain in a year is 6 per cent, as at November 2020." [viii]
In this example, the retiree uses the equity linked protection strategy to generate a regular income stream by withdrawing (without fees) [ix] 4 per cent of their capital annually (the original[x] minimum annual amount required to be paid annually –for retirees under 65 – under superannuation laws). The product allows investors to choose regular withdrawals either monthly, quarterly, half-yearly or annually.
A 4 per cent withdrawal is comparable to the current yield on Australian shares. “The big difference is retirees sleep easier knowing the most they can lose on their investment in a year is 5 per cent “ says Rady.
If Australian equities returned at least 6 per in that year, the retiree’s portfolio would keep up with inflation. “After withdrawing 4 per cent of their capital, the retiree’s portfolio would still grow by 2 per cent, which is a little more than the current rate of inflation,” says Rady.
“Retirees investors are craving this kind of certainty, and it’s time they are delivered the confidence they deserve.”
i The highest 12-month bank term deposit was 1.23% at 2 November 2020, according analysis by comparison website Canstar.
ii Based on S&P/ASX 200 index
iii Matthews, T., “A history of Australian equities,” Research Discussion Paper, Reserve Bank of Australia. June 2019.
iv Lowe, P., “Today’s Monetary Policy Decision”, Reserve Bank of Australia, November 3.
v Callan Associates, “Risky Business”, 2019
vi AARP and the American Council of Life Insurers, “How Retirees manage money to make it last through retirement,” 2007.
vii Based on Allianz Retire+ Powered by PIMCO survey in May 2020 of 1,007 current and prospective retirees
viii Based on the Allianz Retire+ ‘Future Safe Caps and Fixed Rates’. Effective from 1/11/2020-30/11/2020. Caps and Fixed Rates are updated monthly.
ix Based on an investment in Allianz Retire+ Future Safe where withdrawals above the free withdrawal amount are subject to a market value adjustment. Refer to the PDS for a detailed explanation of fees and costs.
x SIS minimum, pre-COVID-19 change to minimum drawdown rate.