Rebuilding a retirement income stream

How to ensure you’ll have enough super to provide a comfortable income stream? Here’s a starting point.

PORTFOLIO POINT: My higher-income/low volatility portfolio can build your super balance to help a comfortable retirement.

With market volatility looking increasingly persistent, more investors want to position portfolios to minimise unpredictable returns. In doing so, they are making sure there is enough capital in their super to produce an income stream that will maintain a comfortable retirement, now and well into the future.

In particular, investors need to ensure they achieve some capital growth during the accumulation stage so the pension stage is adequately supported.

I have constructed a higher-income/low-volatility (HILV) portfolio that has provided a risk-adjusted, high single-digit positive return with low annualised volatility over the past two to three years. This compares favourably with the negative return of the sharemarket over the same period and has done so with dramatically less volatility.

Indeed, the income portfolio's volatility is about half that of the equity market. I like to think the HILV portfolio is a sensible approach for risk-averse investors who already have a satisfactory investment capital base for retirement.

The demand for higher income and lower volatility investment portfolios will become more important given the ageing population of Australia and those of other developed nations such as the US, Europe and North Asia.

Based on the latest ASFA Retirement Standard figures it is estimated that an income stream of $55,000 is required for an “average” couple to be reasonably comfortable in retirement. In contrast, for a couple to enjoy a modest lifestyle, they need about $32,000. I have reproduced the table below; the AFSA website has further detailed analysis.

-Your retirement planner
Modest lifestyle - single
Modest lifestyle – couple
Comfortable lifestyle - single
Comfortable lifestyle - couple
Housing – ongoing
$57.96
$55.64
$67.18
$77.88
Energy
$34.16
$45.37
$34.66
$47.01
Food
$75.74
$156.89
$108.20
$194.76
Clothing
$18.18
$29.52
$39.36
$59.04
Household goods and services
$26.06
$35.33
$73.30
$85.87
Health
$34.75
$67.07
$68.94
$121.68
Transport
$92.21
$94.82
$137.41
$140.02
Leisure
$72.82
$108.48
$220.66
$302.39
Communications
$9.21
$16.12
$25.30
$32.21
Total per week
$421.09
$609.24
$775.03
$1,060.86
Total per year
$21,957
$31,767
$40,412
$55,316
Source: ASFA

Based on the latest ABS data release, note the following:

1. The average wealth of Australian households (including financial and non-financial assets) was $720,000. However, the key data you should look at is the median and this is substantially lower at $426,000. In other words, household net wealth is concentrated at the top end of households.

2. The wealthiest 20% of households have on average $2.2 million of wealth and account for about 66% of total household wealth. Again, this is further skewed to the category of “super rich” as the median of this wealthy grouping is a lot lower at $1.47 million.

3. Wealth is concentrated towards the retirement group with the average age of the top 20% of wealthiest households being 57 years. In this group the mean gross income per week is $2665 (or just over $138,000 a year). Over 61% of this group own their home. This also neatly corresponds to the average household net wealth peaking in the 55–64 age group where the net wealth peaks around $1.15 million. Of this, $782,000 are non-financial assets and mainly a residence. Once non-financial assets are removed from this group they have on average about $400,000 of investable assets.

4. Among the wealthy households, the net wealth dips after age 65. This is not surprising because in this subgroup people have substantially moved into retirement (pension) mode. Income drops with age since capital is deployed for living expenses. This is clearly shown by the fact that the average net wealth of household peaks in the 55–64 age group and drops off to below $780,000 for those households of 75 years or older.

Using the information above, it is possible to construct an HILV portfolio that aims to achieve the minimum sum most people need to retire comfortably. I believe it is important for individuals and couples to consider their targeted objective and set realistic goals.

-Our starting parameters are
Value Comments
ASX200 4,200 November 2011
Inflation 3.0% pa RBA’s upper target range
BBSW 90 4.60% November 2011
Portfolio volatility 7.5% to 8.0% pa See footnote
Household income $138,000 See ABS data or point 3 above
Initial sum $400,000 See ABS data or point 3 above
Pay increment 3.00% Assume similar to inflation
Time frame 8 to 10 years Accumulation phase prior to retirement
* This is an indication based on an extensive modelling on our model HILV portfolio over different times.

In addition, to be conservative I have built into the models the probability of a 33% negative return of the HILV portfolio in any one year (note the recent example of 2008). I then calculate the percentage of household savings required per annum to achieve an income stream that will provide a comfortable lifestyle in retirement. Furthermore, this strategy must be executed via a DIY superannuation fund, noting particularly the net saving in taxes for higher gross mean income groups through salary sacrifice.

Based on the latest ABS data, we can define the typical approaching-retirement couple as those with the following characteristics:

  • A median age of 57.
  • With average financial assets of $400,000.
  • Household income of $138,000 pa.
  • Own their home outright.

With a median age of 57, this implies that there is a maximum time frame of about eight to 10 years to retirement for this subgroup.

Based on this information it’s possible to do some longer-term modelling to determine the minimum amount of contributions people need to make to the household’s accumulation super account.

The goal is for the present value of the income generated from the accumulated capital to be above $55,000 in eight to 10 years’ time, from the starting amount of $400,000. Also assume that at retirement, the strategy of the HILV portfolio remains unchanged, to provide for an income stream instead of cashing out.

The modelling suggests that a typical couple who fit into the top 20% of wealthiest households would still need to increase their contributions into superannuation from the compulsory 9% to about 25% to achieve a comfortable retirement once the head of the household reaches 65 in eight years’ time. Alternatively, they can work an additional two years until they are 67 and the additional contribution to the DIY super account would drop to 20% (ie, 11% additional salary sacrifices) from 25%.

On the other hand, if the household started with an initial sum of $500,000 in investable assets instead of $400,000, the addition superannuation contribution they have to make would be 15% to retire at age 65. In another scenario, if this typical household aims to stop working at age 67, they only require 11% (2% above the 9% compulsory superannuation) to achieve a comfortable retirement.

This relationship between the percentage of household income that needs to be channelled into a DIY superannuation account and the initial starting amount of investable assets at age 57 (with a household gross income per annum of $138,000) is vividly represented in the chart below.

Remember this modelling does not take into account one-off circumstances such as sickness in the family, loss of a job, or separation/divorce and it is imperative that people build in a buffer for unforeseeable circumstances. This implies that higher superannuation contributions above the minimum amount are advisable.

We know that the developed world is moving into a slower growth environment as a result of deleveraging, so those approaching retirement should seriously reassess their risk and return profiles to re-evaluate their strategy for a comfortable retirement.

Vincent Chin is a senior analyst at the Clime Group. Clime’s investment committee utilises MyClime, Clime's online stock valuation and research service to determine their stock selections. For a free two week trial to MyClime, click here.