How to ease the risk of untimely losses

Think about it. When we're saving for retirement, when are we most vulnerable? It's not while we're working and saving for the future. A loss then might set our plans back a bit, and we may even need to rethink our savings plans, but we have the time and income to get back on track.

Surprisingly, it's not during the later years of retirement, either. If investment markets have been good to us, all those plans we worked on earlier should be bearing fruit and we no longer have to worry about stretching our savings for another 20 or 30 years.

But get hit with a big loss just after retirement and the picture is bleak.

The graphs from Russell Investments look at the experiences of two retirees over the 20 years from 1989 to 2009. Both track the account balance of someone who retires with $700,000 in today's dollars and draws down an income of $50,000 a year (again adjusted for inflation).

The first graph assumes the investor earned the median return of balanced super funds - the style of investment most commonly used. While both the tech wreck and the GFC take a toll, they still finish their 20th year in retirement with about $300,000 in their account - not bad considering they've drawn down the equivalent of about $1 million in income. Chances are, this should be enough to see them out comfortably.

But what happens if, like many recent retirees, you lose money soon after retiring?

The second graph uses the same median fund returns as the first but reverses them so the GFC losses are incurred at the start, rather than the end, of the 20-year period.

The account balance has dipped below $500,000 less than two years into retirement. And when the tech wreck leads to further losses a few years later, the account balance starts to plummet again.

Despite the average annual return over the 20 years being identical in both cases, the investor who was hit early by the GFC has run out of money just 15 years into retirement.

The experiences of retirees in the GFC has led Russell Investments to research the effect of early losses in retirement and how risk at this stage can be better managed. The results so far will be presented to the group's investment seminars in Melbourne and Sydney next week.

Russell Investments' director of superannuation, Tim Furlan, says while it hasn't found a magic bullet to protect retirees from GFC-style losses, it has identified several "levers" than can reduce the risks. Combined, he says, they can effectively prevent a wipe-out such as we saw in the second graph.

The first is asset allocation - or where your money is invested. If you simply can't afford to take a big hit, putting at least some of your money into more conservative investments is an obvious way of protecting it.

But while putting all your money into cash might be safe, you will generally pay a price in lower investment returns.

Furlan says the optimum solution isn't to be super-conservative but to maximise retirement income while reducing risk.

That's where so-called life-cycle funds, which automatically switch you to more conservative investments as you get older, don't fully deliver. They don't take account of other forms of protection and, as Furlan points out, they most typically leave you in the same asset mix all through retirement.

"There's an argument that as you move through retirement, you can actually be more aggressive," he says.

If you can afford it, he says, planning a "buffer" or a bit extra in your account can reduce the impact of losses and the age pension can also be used for partial protection in supplementing your income if your account balance falls.

He says other levers include withdrawing less from your super if you are able to and the ability to keep working or to increase your work hours if things go wrong.

Because drawing an income accelerates the flow of money out of your account, Furlan says any strategies to reduce drawdowns in bad times will help your recovery.

One set of modelling undertaken by Russell showed that if an investor withdrew a fixed proportion of their account balance rather than a set dollar amount, they would end up in the same situation in both scenarios. However, in the first case (where losses were incurred later in retirement), they would have drawn down an income of more than $1 million in the second scenario, where losses hit early, their income would be about $600,000.

Surprisingly, the common strategy of keeping two or three years' worth of income payments in cash did not deliver the protection expected in Russell's modelling. Furlan says this strategy would have resulted in an investor running out of money after 14 years in the second graph, as investors still got hit by the losses on most of their account balance and had to switch money to cash to "replenish" their stockpile when markets were down.