PORTFOLIO POINT: Knowing the key financial risks can put investors in a better state of wealth.
These are worrying times to be an investor, but proactively focusing on the biggest risks you face might help you protect your wealth and sleep better at night.
These are the five major risks that could derail your wealth building and retirement plans:
- Could you outlive your investments? (longevity risk).
- Could inflation outperform your investment return? (inflation, economic and market risks).
- If governments mismanage their finances, could they interfere more with yours? (legislative and sovereign risk).
- Will ill health in your family kill or cost you? (health risks).
- Could you or others mismanage your investments? (various investment and agency risks).
While all these risks are inter-related, we should discuss them one by one. Then we can look at how you can manage them – and try not to become too despondent.
Risk 1: Longevity risk
Knowing how long you and your partner are going to live dictates how much capital you need to set aside to fund retirement, or if you are already in retirement, understand what is your prudent annual spending amount. For instance, if you somehow knew you will live to 80 not 90, then you need 30% less capital to retire at age 65 or could spend 35% more with the capital you have. Since this is impossible to know, many investors instead plan for an average life expectancy (Figure 1).
Figure 1: Australian life expectancy tables 1997-2002
Unfortunately 50% of the time this could cause you to outlive your investments. Alternatively, if you plan conservatively that you will live to your 90% life expectancy, then 90% of the time you are likely to be wrong and could have spent more or retired earlier with less. Of course this funding puzzle is even more complicated when we next talk about uncertainties about inflation and investment returns – but more on that later.
Your best defence against longevity risk is a lifetime defined benefit (DB) pension, if you are lucky enough to be offered one, or a privately arranged lifetime annuity if not.
While the features of each DB plan are different and so is the solvency of the employer or government guarantor, it’s hard not to justify not taking up that option at least for part of your investment strategy. A lifetime annuity offers “longevity insurance” and behaves like “reverse life insurance” – after you pay an insurer a lump sum, they pay you back an annual income until you die. Both products have a head start against the self-funded retiree. This is because they “pool” the risk of those living longer with those living a short time, and pool the risk of investing in unfavourable times with favourable times, and hence they can plan and payout for average conditions.
Even though annuity sales are up strongly in recent times, few retirees buy the life-time variant, favouring instead fixed-term annuities. Most Australians don’t like the idea of “surrendering” a lump sum of capital over to an insurer, although now one of the two suppliers offers a get your money back within 15 years feature. According to research, “annuitants” outlive the general population by about two or more years. While this could be due to them sleeping better at night or making it a goal to “beat the insurer”, it is probably more to do with “adverse selection” of annuities bought by healthy, wealthy, smart people.
“Deferred annuities” have been talked about generally in the marketplace, but aren’t yet available to you in Australia. These products bought at the start of retirement pay out an income only if and after you reach, say, your average life expectancy, and as a consequence are bought with less capital. Compulsory annuitisation could one day be part of the Australian landscape. At the moment if you live longer than your investments your back-up strategy is the government age pension (or your house if you have one and can take equity from it). While most expect to spend less late in retirement, health care costs may rise to fill the gap.
In summary your defences against outliving your money are:
- Pool with others these risks through membership of a DB pension plan or a lifetime annuity that at least covers your minimum living expenses.
- Plan to live longer than average and hence save more and/or spend less considering benchmarks like those I shared earlier.
- Live off income, not capital, but don’t overly tilt your portfolio to income to do so.
- Access later equity in your home through downsizing or reverse mortgages, including perhaps arranged privately with your young 60-year-old cashed up retired children.
- Fall back on the Age Pension.
Risk 2. Inflation and market risks
I have been worried about inflation for many years. This is not just because of current events, but because it is the number one threat to your retirement portfolio longevity, and retirements last long enough for one to expect to encounter it.
Of course with the electronic money printing genie out of the bottle in parts of the world, it pays for you to worry too and be prepared. Note, even if you expect asset price deflation through deleveraging, cost inflation can still continue. In my opinion few in Australian leadership roles seem interested in restraining consumer price rises and globally more and more people are laying claim to scarcer resources.
Earlier I discussed inflation investing strategies including:
- Invest in more inflation tolerant shares like utilities, consumer staples, materials, energy and other commodities, perhaps property trusts and avoid banks, manufacturers and retailers.
- Include more inflation linked bonds in your defensive portfolio and less price-fixed, interest rate sensitive investments like deposits and fixed and floating rate bonds.
- Choose the CPI indexing option in any income stream offered.
- Hedge some of your currency exposure of international investments.
- Pay down debt or fix your interest for 3-5 or more years.
Even in the absence of high inflation, a prolonged period of poor investment returns can put at risk your plans. For instance if your wealth accumulation or retirement modelling was based on you earning a modest 7% annual return each year, then after 10 years you will have probably fallen short of this target return by 2% annually – regardless of whether you were conservative or high-growth investor. After 10 years, this “investment recession” adds up to having a third less investment growth.
Poor returns don’t just come from equity markets but could come from persistently low interest rates, which may be next in our future. The real (after inflation) income return from high credit quality government bonds in Australia is now negative. We’re lucky so far that banks are desperate enough for local depositors’ money to pay an above-inflation return. However those rates could fall and we could easily join the ranks of the rest of the world where real deposit rates are also financially repressive (i.e. negative).
I don’t suggest your primary defence against low interest rate returns is to chase higher yielding, higher-risk bond-like investments. While the relative premium for doing so is probably higher now than it ever was, that’s the market saying it might not be a worthwhile adventure. Instead consider using an exposure to low yielding but highly conservative bonds and long duration term deposits, to justify investing in more price-volatile equities – and in the current environment higher dividend paying stocks. While it is very likely we will have a number of stockmarket price collapses from here, we will likely also have recoveries, and if you want to earn a higher after-tax franked income you just have to live with volatility and be a reluctant equity investor. Generally speaking your risks of investing in equities is less when prices are lower and the premium you get for investing in them is higher.
So, to recap, in case of prolonged poor equity returns and low interest rates:
- Be a reluctant equity investor and enjoy your (franked) dividend income.
- Avoid chasing higher interest returns in case you trade extra income for lost or frozen capital.
- Lock into higher interest rates through fixed-interest bonds and long duration TDs.
- Adopt prudent withdrawal/spending limits and stop worrying, if you are.
- Consider supplementing your savings with earned income a little longer.
- Screen out investing in companies with large pension funding liabilities.
Risk 3. Sovereign and legislative risks
In Act III of the continuing GFC drama, we see Western governments around the world floundering to fulfil promises of support to lower and middle income classes and to fund bank welfare. In Act IV we will likely see some sort of dramatic resolution involving retirement of sovereign debt using central bank invented money and possibly confiscated private wealth. If not, then this play will become an awfully long Wagnerian-Kabuki tragedy.
Sovereign and legislative risks are a basket of risks about governments changing rules to get more of your money, and giving you less of theirs including not paying back what they owe. In a prolonged period of economic recession the pressures for these rise each day, which are absent in periods of prosperity.
In Australia we are protected somewhat from these global pressures, however we are not immune to world events and have seen already how problems in global financial markets have infected our sharemarket and now are causing interest rates to decline. At the moment government debt levels can be increased when tax receipts don’t equal spending, but there are limits to this.
New taxes on mining company profits and reductions in superannuation contribution limits for everyone over 50 are two local changes that have already played out. In my crystal ball I can see in my lifetime: taxation of pension investment income and perhaps even pension payments and “unreasonable benefits” again, reductions next in non-concessional contribution limits, government directed asset allocation, incentivised then forced annuity purchasing, delayed age pension entitlements and superannuation preservation age, continued “pausing of indexation” of benefits, surcharges, more asset based taxes '¦ crack! Sorry this is even too much for my crystal ball to bear.
However, rather than give up on super and put your investments at even greater risk outside its tax shelter, it is realistic to expect that super will remain relatively attractive. In fact you probably need to make greater use of it now to avoid being disadvantaged by future changes – especially as benefits are often “grandfathered”, although that can lead to Act V “The Inter-Generational Revolt”.
Your defence against sovereign and legislative risks includes:
- Being smarter with super including maximising your incentivised concessional contributions and making after-tax contributions. Consider “cash-out and recontribution” strategies to reduce your taxable amounts, split benefits where you can with your spouse, start pensions early, “manage” your capital gains even if you are in pension phase, and make pensions reversionary (a pension stream that is payable to someone else, such as a spouse).
- With new higher tax-free income limits, don’t be afraid to have some income assets outside super.
- Scrutinise international bond investments, especially index and high yield funds, and ask who they are lending your money to – this a bigger concern than international share investing as with that you’re not buying sovereign equity.
- Limit or avoid investments that only make sense due to tax structuring (including negative geared shares and property).
- Don’t rely solely on property investing as it is the easiest asset class for governments to meddle with.
- Decide if Australia’s sharemarket and economy are “golden” and, if not, buy into gold miners, coins, bars or electronic or certificated versions.
Risk 4. Health risks
Ill health can interfere with your financial plans two ways. Firstly, prolonged ill health or death of both income earners and carers derail pre-retirement wealth building. Secondly, prolonged ill health of you or your partner in retirement could create a substantial drain on your finances.
Healthy living aside, the obvious way for wealth accumulators to manage this risk is through life insurance, which is not expensive for its purpose. Because of automatic cover in employer super, Australians are more at risk of under-insurance than un-insurance. Your lump sum insurance needs may simply be your (retirement) spending target times 25 or 30 (if highly taxed), plus money owed, less existing savings.
Generally it decreases every year as you get past the marriage, mortgage and midgets “triple M” phase. If you have an income, then ensure that it’s paid to you to age 65 (not for two years).
Private health insurance is one way to alleviate the potential drain on your finances from prolonged ill health in retirement. Obviously in Australia we are blessed with a quality public health service, however the cost of additional treatment may be less and recuperation faster with private insurance.
Another consideration is to make sure you have given instructions to your family on how you want to be treated and give them a Medical Power of Attorney. As mentioned before it is very important to ensure you have thought through your “investment succession”, especially if you are the primary investment decision maker.
So health risks to wealth can be managed by:
- Having adequate death and disability lump sum insurance while accumulating wealth.
- Insuring your income so it continues if you can’t earn it owing to ill-health.
- Ensuring this applies to you, your spouse and your children.
- Having private health insurance.
- Documenting your medical and investment wishes.
- Adopting healthy habits!
A related risk is that of prolonged un- and under-employment, which I talked about briefly before, which perhaps can be better managed applying a risk lens to key career decisions. To avoid wealth leakage through divorce, invest in your marriage!
Risk 5. Investment mismanagement risk
Lastly you, your adviser or fund manager might not prove to be a good investor or may just be an unlucky one. If you don’t benchmark returns and portfolio construction you have no idea if either of this applies to you. Risk management is at the heart of investing, as we only get to pick the risks we want be rewarded for. Prudent investment management means managing various risks:
- Market risk (discussed earlier), which is the risk shares continue to suffer declines and you have too many of them.
- Stock specific and sector risk, which arises when you have too much invested in (or lent to) an underperforming company or industry sector (possible with miners and banks given our market construction.
- Interest rate risk, where price-fixed (by the RBA) returns aren’t enough to help you beat inflationary price rises and you have too many investments depending on that.
- Reinvestment risk where future interest rates are less than those available today and you wished you had bought a longer duration TD or a fixed-rate bond (fund).
- Credit and maturity risk, which are the two factors that govern whether you will get the money you lent back or enough of it if interest rates rise respectively.
- Illiquidity risk, which is the chance access to your money remains frozen, like it still is for hundreds of thousands of Australian investors in mortgage and unlisted property funds.
- Currency risk, where you might find a collapsed Australian dollar raises your internationally priced goods cost or where a high Australian dollar (a Bradbury currency) takes away your international share gains.
- Manager risk, where your past star managed fund provider gives you a poor return on your investment in their fees.
- Counterparty risk, where those you have bought downside protection from can’t stump up to reimburse you – and derivative risk where you can’t.
- Custody risks, where the control of your asset isn’t separated from a manager or broker and your fortune is tied their ongoing solvency.
- Fraud risk, where investments prove to be too good to be true unfortunately.
- Operational risks, where you or your fund manager lose track of or misprice assets.
- Tenant, (your or neighbouring) development, financing, resale and many other direct property specific risks.
- Timing risk, where you make large rapid changes in asset allocation at just the wrong time.
- Sequence of returns risk, which means you don’t want to retire just before or into difficult market conditions (especially when partly living off capital)
- Solvency risk, which basically means your pension provider can’t deliver on its promises.
After due diligence, diversification or spreading your bets is the best way to absorb rather than be devastated by a failure. It means your default position must be to have an allocation to shares; both local and overseas, growth and defensive, big and small; have defensive high credit quality bonds including inflation-linked bonds and government guaranteed cash; have listed not unlisted property and infrastructure exposure, and maybe some precious metals in case neither shares nor bonds perform. If your asset allocation isn’t what you want it to be, or you have had a windfall, it may be safer to bet against your intuition and move to it more slowly to manage investment timing risk.
Having documented so many different ways your financial goals may not be achieved, I must confess to worrying more myself and now suffering “sleep risk”. I hope that this is not the case for you and that this inventory might help you put your financial security at less risk.
Dr Doug Turek is Managing Director of family wealth advisory and money management firm Professional Wealth.