Retirees tend to view the world very differently to accumulators. As a result, this cohort of clients is likely to require different approaches compared to accumulator clients. Financial advisers may need to use new strategies and thinking to best help them.
In particular, when people enter retirement their views on, and appetite for, risk may change quite dramatically. But if they are to achieve their desired lifestyle in retirement, then retirees still need to take some measured investment risk with their invested assets. Risk management becomes an even more critical element of their portfolio than it is for those who are saving for retirement.
Therefore financial advisers may need to adjust the way they build investment strategies to ensure they meet these different requirements while appropriately managing risk.
The main investment risks for retirees include:
Market risk is, simply, the risk of losing money when a market falls, and market risk is an issue for all investors. But retirees’ reduced risk capacity makes them more sensitive to a falling market.
Market turmoil, such as that during the global financial crisis, can result in retirees’ capital being seriously depleted and reduce their long-term ability to generate income. Those who panicked and sold out at the bottom of the market may never have recouped their capital losses.
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.
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 a time when markets have also dropped and the value of their portfolio has fallen.
Put simply, longevity risk is the risk of people outliving their savings – i.e. longer than their savings will produce an adequate level of income. Longevity risk has become a growing issue for retirees as life expectancy for Australians has been increasing.
Inflation risk describes the tendency for the cost of goods and services to increase over time. If retirees’ income does not increase by at least the same rate as inflation, over time their income in real terms will be reduced, meaning they buy fewer of those goods and services with the same income.
Retiree households generally experience different price inflation than the households of those in the accumulation stage of saving for retirement. Focusing on the broad CPI figure risks overlooking a retiree’s actual experience. Employee households tend to spend more on things like housing, kids’ education, and transport, while self-funded retirees tend to spend more money on luxury items and on recreation and leisure pursuits and, as they get older, healthcare. These different spending requirements, and the relevant CPI figure, need to be taken into account in retirement planning.
Part of a financial planner’s role is 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.
In theory, it’s relatively straightforward to work out the rate of investment return needed to achieve a client’s goals and, by extension, the amount of risk they will need to take to achieve those returns – their risk requirement.
However, in practice it’s not always as straightforward. Every client views risk in a deeply personal way. A client’s risk tolerance describes their subjective attitude towards taking risk.
From time to time, advisers may need to work with clients on their risk tolerance, to make them more comfortable with taking the level of risk they need to achieve their goals. Conversely, in some cases a planner may find themselves counselling clients against taking more risk than they can afford.
Even if an investor is emotionally or psychologically willing to take risk, they may not be able to afford to. Investors are constrained by their risk capacity, which is an objective measure of an investor’s ability to endure fluctuations in portfolio value without materially affecting their living standards.
Indeed an important factor that distinguishes retirees from pre-retirees 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.
But dollar-cost averaging in decumulation works against the retired investor. Drawing an income when markets are depressed leads to a permanent loss of capital. And a retiree’s need to take some risk with their retirement savings can mean they end up investing in assets that put too great a portion of their capital at risk, which in turn may critically compromise their lifetime income objectives.
A certain level of risk-taking is necessary in every retiree’s portfolio. A good retirement investment strategy balances all of the risk considerations for retirees. In short, it meets the retiree’s financial needs and doesn’t keep them awake at night worrying about their investments. The role of financial advisers in helping retirees achieve this is becoming increasingly important.
Richard Dinham, head of client solutions and retirement, Fidelity