How retirees’ investment needs differ from accumulators

A retiree views the world very differently from someone still in the workforce, and a good financial planner understands how their view of the world changes over time.

An individual might look and sound today just the same as a few months ago, but after they retire, they can become quite different as an investor. And from an investment perspective, perhaps the single largest change observed by adviser, is how a client relates to and responds to risk – in its many and varied forms. The investment risks most relevant for retirees are described below.

Market risk

All investors face market risk, regardless of their retirement status. Market risk is, simply, the risk of losing money when a market they are invested in falls. But retirees’ reduced risk capacity makes them more sensitive to a falling market. The market turmoil of the Global Financial Crisis is an extreme example, which resulted in many Australians’ retirement plans being disrupted. Those who were approaching retirement or were in the early stages of retirement at that time saw their capital depleted, with consequences for longer-term income generation. Some may never have recouped their capital losses – particularly those who were spooked enough to withdraw from investment markets in favour of holding cash. It may be too early to say whether the COVID-19 crisis will have a similar impact, but it is certainly adding to people’s worries.

Sequence of return risk

Sequence of return (or sequencing) risk is a variation of market risk and is the risk that an investor will be forced to draw down on their savings at time when the value of their portfolio has fallen, or is falling.

Longevity risk

Retirees also face risks that are distinctive to them. Put simply, longevity risk is the risk of living too long – in this context, ‘too long’ means longer than their savings will produce an adequate level of income.

Longevity risk has become a growing issue for retirees with life expectancy increasing. Individuals are facing the task of generating income over a period of time that is consistently lengthening and representing a growing proportion of the period of time available to them to accumulate savings. This is usually a bigger issue for females than for males, due to females’ longer life expectancy.

Inflation risk

Inflation describes the tendency for the cost of goods and services to increase over time. As the costs of goods and services increases, the income required to acquire a given basket of those goods also increases. If retirees’ income does not increase over time by at least the same rate as the inflation they experience, they will find over time that their income allows them to buy fewer of those goods and services.

The Reserve Bank of Australia aims to achieve a medium-term average inflation rate of 2% to 3% a year. But inflation varies for different types of households, depending on what they spend their money on. For example, self-funded retirees tend to spend more money on luxury items and on recreation and leisure pursuits, and as they get older will spend more on healthcare. Employee households, on the other hand, tend to spend more on things like housing, kids’ education, and transport.

Retiree households therefore generally experience different price inflation than employee households, and focusing on the broad CPI figure risks overlooking a retiree’s actual experience. The chart below shows how different rates of inflation have been experienced by employees and retirees. Since the goal of retirement planning is to maintain a level of consumption that supports a certain lifestyle, it is important to factor in price inflation that is relevant to retirees’ own lifestyles. The ongoing erosion of retirees’ spending power as a result of even just modest inflation is a risk that advisers need to help them manage.

The retiree’s risk requirement, tolerance and capacity

Retirees still need to take some measured investment risk with their superannuation assets otherwise investment outcomes will certainly be less than needed to achieve lifestyle goals. However, attitudes to risk inevitably change when investors move into retirement and their investment time horizon will become shorter. Therefore, risk management becomes an even more critical element of retirees’ portfolio management than it is for those saving for retirement.

An effective investment strategy needs to be constructed with close regard to an investor’s risk profile. And a risk profile can be assessed from three distinct perspectives:

■ Risk tolerance

■ Risk capacity

■ Risk requirement

Every investor must take some level of investment risk to achieve a targeted investment return – those two things are inextricably linked. Part of a financial planner’s job is to take a client from where they are today and get them to where they want to be at some point in the future, defined by their goals, expectations and desires in retirement. It’s a relatively straightforward task in principle to work out the rate of investment return needed to achieve those goals and, by extension, the amount of risk they will need to take to achieve those returns – their risk requirement.

However, it’s not quite that straightforward in practice. Each individual views risk in a deeply personal way. A client’s risk tolerance describes their subjective attitude towards taking risk, this is the component assessed by risk profiling tools that ask questions like ‘how would you feel if the value of your portfolio fell by 20% overnight?’. Some might fall apart emotionally (and physically), whilst others might shrug their shoulders. How would you fare?

Even if an investor is emotionally or psychologically willing to take risk, they may not be able to afford to. In other words, an investor can be constrained by their risk capacity, which is an objective measure of their ability to endure fluctuations in portfolio value without materially affecting their living standards.

It is an important part of the financial planner’s role to determine and understand each client’s risk requirement to achieve their goals, the client’s tolerance for risk, and their capacity to bear investment risk.

From time to time, they may need to tackle a client’s risk tolerance, perhaps through education about investment issues, to make them more comfortable with taking the level of risk they need to achieve their goals. In some cases, a planner may even need to talk a client down from taking more risk than they need to, or they may find themselves counselling clients against taking more risk than they can afford.

One important factor that distinguishes retirees from pre-retirees, or accumulators, is their reduced risk capacity. Accumulators can more comfortably navigate through a market downturn by increasing their savings rate, or possibly even by taking slightly more risk and waiting for the market to turn around or just continuing to invest contributions on a regular basis. This is the power of dollar- cost averaging which works to the benefit of the investor when saving for retirement.

Dollar-cost averaging in decumulation can - in certain circumstances - work against the retired investor – drawing an income when markets are depressed, which could possibly lead to a permanent loss of capital. And a retiree’s need to take some risk with their retirement savings can mean that excessive risk may be taken by investing in assets that put too great a portion of their capital at risk, which in turn may critically compromise their lifetime income objectives.

As we have seen, a certain level of risk-taking is necessary in every retiree’s portfolio. A good retirement investment strategy balances all the three perspectives of an investor’s risk profile. It meets the retiree’s financial needs and doesn’t keep them awake at night worrying about their investments.

At Humble Goode Financial, we always take risk tolerance, risk capacity and risk requirements into consideration when helping our valued clients develop retirement portfolios. We think about market cycles and time frames for access to your capital, to ensure you are in the best position for the future.

Why not give us a call to learn more about your retirement journey?