Running the retirement marathon
The prudent retiree should plan to live until at least 90 years of age. But what about the average SMSF member?
While we all have different plans for our own retirement, most of us share the common goal to make our money last as long as we do.
In fact, research by over 50s lobby group National Seniors Australia indicates that nearly 70 per cent of surveyed respondents think it’s very important for their savings to last their lifetime.
But what is this lifetime? How long will our retirement savings need to last?
Life expectancy estimates from the Australian Bureau of Statistics (ABS) indicate a 65-year old man today will live to 84, and a woman until 87. These numbers are actually underestimates because mortality improvements from medical advancements and lifestyle improvements can be expected to add two to four years to these figures.
Importantly, what’s often overlooked is that these are only ‘averages’, drawn from historical populations. That is, half of people will live longer than the projected average.
While there’s no publicly available data on the life expectancies of the SMSF cohort, it’s reasonable to expect that they might live longer than the general population because they tend to reflect the educational, occupational and wealth profile of the statistically longer-lived, hereditary and genetic factors aside. However, as the size of the SMSF sector grows, its characteristics will be indistinguishable from the general population.
Because nearly 70 per cent of SMSFs are to the benefit of two members (generally a couple), their pool of savings will need to last even longer. Modelling by Challenger based on Treasury estimates of survival shows there is a 50 per cent probability that at least one member of a 65-year-old couple will survive until age 93.
So although SMSFs have higher account balances than other super accounts, they might also need to last longer due to members’ greater longevity. If you assume that SMSF members will also desire higher income drawdowns, it soon becomes clear that every SMSF should have a plan to deal with some of the risks associated with living a longer life.
The risk of living a long time and running out of money in retirement is called longevity risk and is one of the three key retirement risks; the other two relate to market volatility and inflation.
Market risk is the chance that an investor’s balance will be eroded or depleted by market falls, which history tells us will occur regularly in the stock market. While market corrections will have occurred during the superannuation savings stage, the need for income in retirement exacerbates the negative impact of a market fall.
Not only is your balance hit with a large loss of value, the drawing of regular income might need to be funded by the sale of assets at low prices. Sequencing risk is a form of market risk, which just refers to getting investment returns in an adverse order. Capital will be far more rapidly depleted if there’s a 30 per cent market fall at 65, when wealth is at its peak, than 85.
Inflation risk is the risk that the rising cost of living will significantly erode the purchasing power of savings. Often called the silent risk, inflation risk is creeping and insidious, becoming apparent many years into the future when it’s usually too late to do anything about it.
Fortunately, most SMSF trustees are more aware of market, inflation and longevity risk than other superannuants and have some understanding of the various strategies to hedge them.
One strategy to hedge longevity risk is to accumulate a large enough pool of superannuation assets such that you can maintain your desired standard of living at an acceptable level of spending, well beyond your life expectancy.
As a guide to spending in retirement, the Association of Superannuation Funds of Australia (ASFA) benchmarks the annual budget to fund modest and comfortable lifestyles. According to its March 2013 figures, $41,169 is required to fund a comfortable lifestyle for a single person and $56,317 for a couple. Of course it is likely that many SMSF members aspire to a lifestyle that will cost substantially more to fund each year.
According to the Australian Taxation Office, the average account balance for an SMSF for members over 65 is $772,000. Given that SMSFs generally comprise a couple, this equates to around $386,000 for each member.
Fortunately for SMSFs aspiring to the ASFA comfortable standard, this is more than the $680,000 required to fund a comfortable lifestyle in retirement for a 65 year-old couple. This is based on a median life expectancy of 89 years, using Challenger’s Retirement Calculator, which also assumes a balanced investment strategy (half growth/half defensive) and annual compounded investment returns of 7 per cent.
But, unfortunately, the average SMSF balance of $772,000 is far less than what is required to fund that lifestyle just nine years longer than the median. For one in five couples, one (or both) members can be expected to live to 98. A 65-year-old retiree couple will need to save $1,000,000 if they’re planning for one of them to live to 98.
Another strategy is to under-consume in retirement; a strategy adopted in earnest by the Silent Generation born between 1925 and 1945. This involves living far more frugally than is likely to be acceptable to later generations.
Another strategy available to SMSFs is the laying off of longevity risk to a third party such as an APRA-regulated life insurance company with the scale, experience and expertise to guarantee income payments for life via annuity products.
The approaching introduction of deferred lifetime annuities (DLAs) will also form part of future strategies to hedge longevity risk, being an announcement in the federal Budget favourable to retirees.
DLAs are not currently offered in Australia because they are unfairly taxed compared to other retirement products.
Available in many other countries, however, they are usually bought at retirement, at around age 65, and start generating payments when the retiree reaches median life expectancy for their cohort. DLAs provide a substantial ‘mortality premium’ at a comparatively small price due to the time value of money represented by the ‘unconsumed premiums’ of policyholders who die early. This value is able to be invested and shared between the insurer and surviving policyholders with the effect that the latter can enjoy more attractive annuity payments than would otherwise be available.
The benefit is that DLAs provide pure longevity insurance, freeing up financial advisers and their clients to allocate the balance of super savings as appropriate during the known period between retirement and median life expectancy, which is when a deferred lifetime annuity starts paying income.
While greater life expectancy can be a gift to the SMSF trustee, the potential cost of failing to mitigate longevity risk can exceed the cost of doing so.
Jeremy Cooper is the chairman of retirement income at Challenger.