Unconventional wisdom: Funding your dream retirement
An effective investment strategy for retirement must deal with several challenges while catering for your unique circumstances.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Funding your dream retirement
“If you try to please all, you please none.”
- Aesop
The retirement chancellor doesn’t have the same ring to it as the iron chancellor. But while Otto von Bismark was goose stepping around in his spiked helmet fostering German nationalism he found some time to invent retirement.
The first pension was implemented by Bismark in Germany. It was payable to 70-year-old retirees at a time when life expectancy in Germany was 40. Workers who managed to outlive the average person by 30 years could expect a blissful retirement doing whatever it is that elderly Germans liked to do in 1889.
The maths of retirement is very different these days. Since compulsory superannuation was created in 1992 the life expectancy in Australia has increased from 77 to 84 years old. As the length of time in retirement increases the approach you taken by investors must also change.
Old advice like using your age to set your allocation to fixed interest doesn’t fit retirements that may last as long as the years spent in the workforce.
Solving the retirement conundrum
A retirement investment strategy must solve for several problems. And all this needs to happen in an uncertain future where the length of retirement, the order and level of returns and inflation are all unknowns. Common retirement goals include:
- Not running out of money while generating an inflation adjusted standard of living
- Supporting the lumpy spending of the typical retiree
- Leaving a bequest
The best retirement thinking is supposed to be captured in lifecycle funds. These funds follow a prescribed glide path over the course of retirement where asset allocation changes as the retiree ages.
Glide paths are created using top academic and industry research in investments, behavioral finance, portfolio management, and portfolio construction. JP Morgan described the glide path design in the following way:
“Developing an effective asset allocation strategy requires balancing investment insight and expertise, using tools like modern portfolio theory, glide path simulations, and leveraging time-tested long-term capital market assumptions to evaluate risk and return expectations for the future. The efficient frontier concept is often used to optimize investment combinations, providing the greatest expected return for a given level of risk.”
Got it? Good. Given this process you might think there would be a consensus on the best glide path approach. There isn’t. Different fund managers have different glide paths.
They also tend to change. In a study in the Pacific Basin Finance Journal titled Increased risk-taking by lifecycle fundsthe authors showed the extent of change. In between 2014 and 2022 the average equity allocation in Australian lifecycle funds for investors in their 60s more than doubled.
Perhaps this is a response to increasing lifespans, but the shift seems too extreme given the relatively short period over which it occurred. The change isn’t a rational response to market conditions as valuations have risen which lowers future expected returns.
My cynical view is all the research behind lifecycle funds got thrown out the window and the fund managers are simply chasing returns as investors are unlikely to invest in a lifecycle fund with returns trailing surging equity markets.
A solution fit for all that isn’t right for any
The challenge with a lifecycle strategy is the solution needs to work for everyone. A solution for everyone needs to be good enough for all eventualities which means it isn’t the best solution for any single situation.
A perfect solution is unique to the circumstances for each retiree. To come up with what is best for you means looking at each of the problems a retirement investment strategy is looking to solve and figuring out where your priorities lay.
Problem one: Not running out of money while supporting an inflation adjusted standard of living
This is the base case for retirement. Not running out of money could be supporting the retirement of your dreams, just getting by or something in-between.
The safest way to do this is by putting your portfolio into an inflation protected annuity. An annuity protects you from longevity risk so financial worries about living a long life are addressed. An annuity also protects you from sequencing risk so retiring into a bear market isn’t an issue. The problem with an annuity is that it also limits your upside.
If a retiree chooses to not use an annuity a trade-off must be made between growth assets that earn high enough returns to protect against longevity risk and inflation and defensive assets that lower portfolio volatility protecting against sequencing risk.
This is where a lifecycle fund comes in. But a lifecycle fund doesn’t account for individual circumstances.
Imagine two hypothetical 65-year-old retirees.
Retiree one has paid off their mortgage and only 20% of their spending goes to needs while 80% is decaded to wants like travel, entertainment and recreational activities.
Retiree two still has a mortgage or lives in a rental and 80% of spending goes to needs.
These two individuals should not have the same asset allocation. Common sense would suggest that retiree one can be more aggressive and capture the upside of growth assets given their ability to adjust spending if needed. Retiree two should have more defensive assets given the limited wiggle room in their budget. Asset allocation needs to be fit for purpose.
Problem two: Supporting the lumpy spending of the typical retiree
Typically people spend more money early in retirement when they are healthy and active. This spending then drops as health worsens and finally spikes for end-of-life care.
Like retirement in general the challenge is that there is no set length for any of these phases. However, the earlier you retire and the better health you are in the longer phase one will be.
This common spending pattern is another reason why a one size fits all asset allocation may not be appropriate. Rather than following a glide path based on age it makes sense to continue to heavily rely on growth assets in the high spending phase with an emphasis on wants before shifting to defensive assets when needs make up the majority of spending.
Problem three: The desire to leave a bequest
Helping people or causes you care about is a noble aspiration. The best way to do this is to continue to invest in growth assets and ride out the inevitable volatility in retirement.
This can introduce more stress than would otherwise be needed to address longevity risk while not running out of money and protecting your purchasing power. But the best way to end up with the most money in the future is to invest in assets with the highest expected returns. That means growth assets.
Designing your own strategy
It should be apparent that retirement strategies should be based on your individual circumstances. But there are several tips that may help most people planning their retirement strategy.
Consider an early bequest
If you are in a comfortable position and your goal is to support people or a charity with a bequest consider doing it early. There are several benefits from this approach.
Giving money away early clarifies your retirement strategy. You can focus solely on not running out of money and protecting against inflation. You are also alive to see the benefits of your generosity which can add some fulfillment to your life.
An early gift is more likely to benefit the people you are trying to help. Getting money earlier will have a bigger impact on the lives of your loved ones than waiting for an inheritance.
It also mitigates another risk retirees face – changing tax conditions. It is frustrating when the rules change after you are retired but as Div 296 and the constant tinkering with super shows this does happen.
As Bob Dylan said you don’t need a weatherman to know which way the wind blows. In Australia right now the political winds are directed towards lowering generational inequality by taxing wealth.
You may agree with this, or you may not. But that isn’t going to stop it from happening. If you are fortunate enough to have extra assets it might make sense to dispose of them early before they are eroded by taxes.
Give Bill Perkin’s Die With Zero a read and think about creating some “money dividends” while you still can.
Not all growth assets are the same
Lumping different investments into growth and defensive buckets overshadows the nuances of investing. Some shares are very volatile and some aren’t. Some defensive assets are safe and some aren’t.
A retiree can remain in growth assets while shifting a portfolio into large dividend paying shares which are generally less volatile and less at risk for catastrophic capital losses. For defensive assets there is a big difference in the risk profile of cash or short-term government bonds and private credit or high-yield bonds.
Each investment in your portfolio should play a role which is aligned to your specific retirement circumstances.
Consider a bucket strategy
My own preference for retirement asset allocation is a bucket strategy where safe assets like cash can be used to ride out volatility while growth assets can deliver the returns that deal with longevity risk.
This is a much more effective strategy to deal with sequencing and longevity risk than a lifecycle fund where you sell a little bit of everything to fund a withdraw. When markets are doing well shares can be sold to fund retirement spending. When markets are struggling cash can be used. Dividends and future share sales can refill the cash bucket.
Think about at least partial annuity
My guess is most readers have no interest in an annuity. I get it. People convince themselves that the minute money is sent to an annuity provider a bus will appear out of nowhere and run them down.
Many readers of this article likely find the intellectual challenge of investing compelling. I’m the same way. But if you are in a strong financial position a partial inflation adjusted annuity covering your needs can be a great retirement tool. Especially if you combine it with an early inheritance for your loved ones.
The certainty of an annuity might remove some stress from retirement which is always beneficial.
Final thoughts
Life is about trade-offs and no single strategy is perfect. If you are approaching - or in retirement - write down and rank your goals. Consciously making those trade-offs early is far better than having to respond to future events by compromising what you want out of life.
Shares your thoughts on retirement and email me at mark.lamonica1@morningstar.com
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What I’ve been eating
Fortum & Mason claims they invented the scotch egg in London in 1738. Yet like most edible English food the recipe was likely stolen from India. The origin is suspected to be a dish called nargisi kofta which is a curry featuring an egg wrapped in mince and deep fried.
This particular scotch egg is from a great pub in the Sydney suburb Woolloomooloo called the Old Fitz. Don’t limit your order to their highly acclaimed wagyu burger - throw in a scotch egg unless you have a problem with a soft-yoke egg wapped in a pork shoulder, bacon and sage sausage. Culinary appropriation never tasted so good.
