Understanding capture spread the key to retirement income

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A fundamental shift in the investment strategies offered to Australians will be required to meet the needs of future retirees, according Richard Dinham, head of client solutions and retirement at Fidelity International.

With 65 per cent of Australia’s $2.8 trillion superannuation assets sitting in the hands of fund members aged 50 years and older[1], there is growing recognition that new solutions are needed for people reaching the drawdown phase of their investing lifecycle.

“When people are saving for retirement, the focus tends to be solely on performance.  While that may be appropriate during the accumulation phase, it fails to address the complex needs of those people approaching retirement or in retirement.  As Australia’s enviable superannuation system matures, more people are reaching retirement with large pots of savings, and they are doing so at a point when cash rates are at all-time lows.  This will drive the industry to develop more innovative solutions to meet the needs to today’s retirees.”

Dinham, who joined Fidelity International to support the development of its retirement offering in Australia, said that retirees and advisers would also need more education to help them understand the factors that could impact their retirement outcomes.

“Retirees still need to take appropriate investment risk to address inflation and longevity risk, but there also needs to be a focus on the impact of market volatility on retirement outcomes, known as sequencing risk. While the positive impacts of compounding and dollar cost averaging are well understood when it comes to saving, many people are not aware that the opposite is true during decumulation.  In fact, limiting losses in retirement has a more powerful effect on long term growth than capturing the full upside of market gains.”

Fidelity analysis shows that a 10 per cent investment loss requires an 11 per gain to simply return to the original point before the loss occurred. A 20 per cent investment loss requires a 25 per cent gain, and so on, to the point where a 50 per cent loss needs a 100 per cent gain to simply return to the original balance.

Dinham continues: “While taking some risk in retirement is needed to avoid unpalatable outcomes, it is clear that limiting downward movements in retirement portfolios is even more important than capturing the full upside in markets. You can’t spirit away market risk but you can sensibly manage it.”

Traditional wisdom has it that equity markets – as measured by an index – may be volatile, but over the long term the growth trajectory is generally upwards. However, the impact of this dynamic reverses at the point where people start taking a regular income in retirement.  This is best demonstrated by looking at performance in dollar rather than percentage terms.

Assuming a starting balance of $500,000 and a drawdown of $3000 per month, Mr Dinham compares the performance of four different investing options over the 20 years between August 1999 and August 2019[2].

Over this period, and under these circumstances:

  •  An investment in the MSCI Word Index would see the investor run out of money by May 2014.
  • An investment in a fund capturing 80 per cent downside and 100 per cent upside has a final balance of $402,000 in August 2019.
  • An investment in a fund capturing 80 per cent of the downside and 110 per cent of the upside has a balance of $1,102,000.
  • But an investment in a fund capturing 40 per cent of the downside and only 80 per cent of the upside, has a balance of $1,600,000 at the end of the 20 years.

Mr Dinham says the takeout from these examples is: “Investors still need to take on equity risk, but the compounding effect of investment losses can have a devastating effect on retirement portfolios. Accordingly, the right kind of equity risk in retirement should come with excellent downside capture to protect in down markets and a capture spread that enables sufficient participation in the market upswings.  This approach has been shown to deliver better outcomes in retirement.”

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[1] Source:  ASIC, as at June 2017
[2] Source: Fidelity International. For illustrative purposes only. Data to 31 August 2019.

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