Guaranteeing Investment Success

Transcription

1 Guaranteeing Investment Success By Michael Furey, Head of Research Suncorp Financial Services It s been well documented that one of the major challenges for the Australian social security system is our ageing population. Currently there are approximately 5 working people for every person aged over 65 and this ratio is projected to decrease to 2.7 workers by This trend places significant strain on Australia s social security system and irrespective of the Australian government s strategies, relying on the government s age pension in the future may be a risk not worth accepting. As a result, the most appropriate action for Australian workers is to focus on funding their own retirement. A recent Suncorp Life survey 2 suggests 55% of Australians aren t confident they ll have enough superannuation to live for 20 years in retirement. Despite this lack of confidence, only 32% are willing to top up their superannuation from 9% to 12% themselves from their pre-tax pay in order to have sufficient retirement savings. The combination of these two results suggests that while most Australians believe they won t have sufficient super at retirement, many are not prepared or feel unable to do anything about it. This appears to further supporting evidence of nthe widely held belief that Australians are disengaged from their super, however, when asked why they re not willing to top up super, 32% said they cannot afford to pay more than 9% and another 25% said they prefer to have money now for current mortgage/bills/everyday expenses. So while there may be the perception of super disengagement, for some the current cost of living prevents them from taking the simple step of increasing contributions towards achieving a self-funded retirement, even though they are aware that it s necessary. For the Australian financial adviser, this situation is quite a common scenario. When a client is not prepared to contribute more to superannuation to reach their retirement goals, many financial advisers accept it without further question and then simply recommend their client invest more in shares to increase the return potential. Unfortunately, to many advisers the focus on investment strategy is regarded as sufficient as opposed to providing additional advice on how to better manage personal debt levels and cash flow. The opportunity for advisers to add value is by improving clients cash flow. To support this hypothesis we model two scenarios. In Scenario 1, we compare the impact of the increase in salary sacrifice from 9% to 14% to simply increasing the portfolio return potential. In Scenario 2 we show how increasing savings is essential when retirement planning for those who are not willing to postpone retirement. Methodology Each scenario uses Monte Carlo Simulation to forecast the probability of reaching retirement. For the sake of simplicity, achieving retirement is defined as accumulating enough funds to purchase a 1 Australia to 2050: future challenges circulated by The Hon. Wayne Swan MP Treasurer of the Commonwealth of Australia January Suncorp Life survey conducted between April and May 2010, 1,650 working Australians between the ages of 18 to 64. Survey conducted on behalf of Suncorp Life by Colmar Brunton. 1

2 20 year nil residual capital value inflation linked annuity in terms of the retirement income goal. Today s pricing indicates the cost of this inflation-linked annuity is approximately 14 times required inflation linked income, so for a desired income of $40,000, the required balance is $560,000 in today s dollars. Please note, while life expectancy may in fact be greater than 20 years we use this timeframe simply for illustrative purposes. Table 1 shows the expected returns and risk and Table 2 shows the assumptions used for each simulation. All returns are randomly generated from a normal distribution where the expected return used is the Expected After-tax Return and the standard deviation is the Expected Annualised Risk. All results are based on 1,000 simulated scenarios. Table 1 Return Assumptions Gross Expected Expected Expected Investment Strategy Expected Return Expected Income Capital Growth After-tax Return Annualised Risk (St Dev) Conservative (20% Growth) 6.6% 5.1% 1.5% 5.8% 3.5% Moderate (40% Growth) 7.2% 4.7% 2.5% 6.5% 5.5% Balanced (60% Growth) 7.8% 4.3% 3.5% 7.2% 8.0% Growth (80% Growth) 8.4% 3.9% 4.5% 7.8% 11.0% High Growth (100% Growth) 9.0% 3.5% 5.5% 8.5% 15.0% Source: Suncorp Life Table 2 Index Assumptions Inflation 2.5% Wages Growth 3.5% Source: Suncorp Life Scenario 1 Choosing to save versus Increasing Return Potential Jim is 40 years of age, earns $80,000pa, has a Balanced risk profile and has $180,000 invested in superannuation. He wishes to retire by age 60 with an income provided by his superannuation of $50,000pa linked to inflation. Chart 1 shows the probability of Jim reaching retirement for each of the five investment strategies as he gets older. Only a High Growth portfolio provides Jim with a better than 50% chance of achieving his retirement goal of retirement at age 60. His current Balanced strategy has around a 1 in 3 chance of success so without the ability to save it leaves Jim little alternative than accept significantly more investment risk or change his retirement goals. A client s risk profile is often the main driver of their investment strategy but, as this scenario shows, it may not actually satisfy their ultimate financial goals. Yet, as an adviser, adopting riskier strategies outside of a client s risk profile requires education, patience, and for many clients it may not be possible to invest outside their comfort zone. And it s risky if there s a sharemarket correction early in the relationship then rightly or wrongly the relationship can be affected. Even if the client is 2

3 comfortable with accepting increased investment risk to increase the chances of reaching their goals, as Chart 1 shows, it is only increasing the chances and there may still be a high probability of failing to reach that desired retirement goal. Chart 1 9% SG Contribution Only Chart 2 shows the probability of reaching retirement if Jim increases his superannuation contributions from the 9% super guarantee (SG) to 14% of his annual income, which in year 1 is a gross salary sacrifice of around $80 per week or a net after-tax cost to weekly cash flow of approximately $55 per week. As it should, the probability of retirement when desired increases for all investment strategies with this additional salary sacrifice but for Jim s current Balanced investment strategy the probability of reaching his retirement goal improves from around 36% to 57%, which is same as the most aggressive strategy, i.e. the High Growth strategy with only a 9% SG contribution. Chart 2 9% SG plus additional 5% Salary Sacrifice The reason for the substantial improvement in retirement chances is quite simple: additional contributions to superannuation are the equivalent of receiving a risk free return on top of the return provided by the chosen strategy. As a result, surely the return on investment for the adviser is likely to be far greater, with less risk if their focus as advisers is on improving their client s cash flow position so they can improve their chances of reaching their financial goals. While ensuring a client 3

4 has an appropriate investment strategy is important, the gains to be had from a simple savings plan appear far greater for both adviser and client and for less risk. Scenario 2 Considering Willingness to Delay Retirement Steve is 53 years of age, and like Jim has a salary of $80,000pa and a Balanced risk profile. He has $450,000 invested in super and wishes to retire by age 60 with an income provided by his super of $50,000pa linked to inflation. Steve is currently salary sacrificing 7% of his salary on top of his usual 9% SG contribution. A question advisers rarely ask their clients, unless desired retirement looks unlikely, is if you re not in a position of retirement at your desired retirement date, how long are you prepared to continue working for? Different answers to this question may in fact result in different investment solutions, even though the desired retirement goal may be the same. Chart 3 shows Steve s chances of reaching retirement given his current super contribution strategy. If Steve insists he has no intention of working beyond age 60, then maximising his chances of reaching retirement without saving more requires a High Growth strategy which only has a little over 60% probability of success. Given the Balanced strategy has a less than 50% chance of success, unless Steve has the ability to save more it appears this strategy places the odds against him of retirement on his desired income at age 60. Chart 3 9% Super Guarantee Plus However, if Steve says that he s prepared to delay his retirement until age 65, then his investment consideration set has a new dimension. While the High Growth investment strategy provides Steve his best chance of retirement at his desired age 60 in this scenario the strategy has the lowest chance of reaching retirement by age 65, i.e. his absolute limit. The reverse is true for the Conservative investment strategy whereby it has the lowest chance of reaching retirement by age 60, it provides Steve the greatest chance of reaching retirement by age 65. The reason the Conservative strategy provides a higher probability of reaching retirement at age 65, and High Growth the lowest, is that as Steve s superannuation balance gets closer to the goal balance, there is a greater chance of a high negative return that significantly reduces the balance from the High Growth Strategy than from the Conservative strategy. 4

5 So this situation creates a dilemma as Steve must choose which goal he is prepared to place at most risk, reaching retirement at his desired age or placing his absolute limit at risk. Once again there is one simple solution and that is to reduce the risks of not reaching retirement by focusing on contributing more. Chart 4 shows the results of Steve contributing $12,000 on top of his 9% SG Contribution. Choosing a Moderate strategy virtually guarantees Steve retirement by age 65 while still providing nearly 60% chance of retirement by age 60. Chart 4 Conclusion With Australians not confident of having sufficient super for retirement and feeling unable to increase their contributions to super, the opportunity for advisers is to provide advice that goes beyond investment strategy and focuses on improving investor s cash flow and savings. Increasing savings, for example by salary sacrificing into super, is the lowest risk way of achieving financial goals and can remove the dilemmas of investing outside of your comfort zone or putting minimum expectations at risk. References Bodie, Z Retirement Investing : A New Approach Australia to 2050: future challenges 5