CPD: Certainty – an essential ingredient for a comfortable retirement

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Financial certainty in retirement can lead to better retirement outcomes your clients.

The state of being completely sure or confident about something, certainty implies a high degree of confidence in a situation. As explored in this article from Allianz Retire+, financial certainty is important to all clients at all stages of life, especially in retirement.

When someone is certain about something, they have little or no doubt regarding its validity. Often subjective and varying from person to person, certainty is generally based on a combination of evidence, personal experience, knowledge and sometimes, intuition.

When it comes to managing finances – both in the accumulation and decumulation phases – certainty is a critical factor in decision-making. Why? Because it helps individuals navigate through life’s complexities and make good decisions with confidence.

However, how certain can one be when considering finances? Attributed to Mark Twain, but spoken by others before him, “The only two certainties in life are death and taxes.” The value of financial advice, however, is to deliver as much financial certainty to clients as possible.

Certainty and the accumulation of assets

The accumulation phase represents a critical stage in a client’s financial journey; it’s the time when your clients start and build a career, find a life partner, and sometimes have a family, and buy their first home.

During this phase, clients diligently work to build their financial foundation, primarily focusing on accumulating investment assets inside superannuation, acquiring other non-super assets and savings. They will have a range of financial and lifestyle goals that you’ll help them attain.

It’s a stage during which strategic financial planning, prudent investment decisions and disciplined savings habits are key. It’s also a period when individuals can harness the power of compounding by consistently contributing to their super and other investments, allowing them to grow over time. Working with your clients to become educated investors is important, both at this life stage and into the future. Setting good groundwork as early as possible in the accumulation phase will help deliver financial certainty in the future.

Whether working full or part time, or as a casual, most Australians can rely on some certainty of income. Although the gig economy and other variations of casual employment has made income certainty less attainable for a portion of the population, it’s available to the majority. For those unable to work because of illness or injury, there are safety nets in the form of insurance – TPD, income protection and trauma cover. Government safety nets are also available, although clients need to be aware of the significant difference in payments between safety nets provided by insurance and government payments.

For example, income protection insurance allows a client to safeguard one of their most important assets – their ability to earn an income. Income protection provides financial support in the event of injury or illness which prevents the client from working. It provides a regular benefit in place of the salary the client would normally earn and, depending on the policy terms and whether the client is fully or partially unable to work, is generally paid at up to 75-80 percent of their pre-disability earnings. The government safety net provides a set amount, currently around $749.20 per fortnight and subject to a range of tests, proofs, and long lead times.

Superannuation

One of the most important contributors to financial certainty in retirement is superannuation. Changes to the Superannuation Guarantee from 1 July 2022 removed the $450 per month minimum income threshold for employees to receive SG contributions from their employer, increasing the number of Australians accumulating super assets. There are also opportunities for voluntary contributions to further enhance future retirement income.

The annual concessional contributions cap is indexed in line with average weekly ordinary time earnings in increments of $2,500, making $27,500 the concessional contributions cap for 2023–24. Those clients with a total superannuation balance of less than $500,000 on 30 June of the previous financial year can carry forward any unused amount of their annual concessional cap for up to five years. This enables them to increase the amount of concessional contributions they can make without exceeding the contributions cap.

Should your client’s contributions push them over the contributions cap, they’ll be liable to pay more tax. However, only the amount above the limit is subject to additional tax. For example, if your client contributed $10,000 over the limit, extra tax would only apply to this amount.

Concessional contributions that exceed the cap are taxed at the client’s marginal tax rate (including the Medicare Levy). For those clients contributing to more than one super account, the contributions cap is combined across all funds.

Risk factors

At the same time as clients are focused on accumulating assets for retirement – as well as meeting a range of financial goals along the way – there are a number of influences that can affect the eventual retirement outcome.

Firstly, there’s inflation, which erodes the purchasing power of each dollar and means a dollar saved today may be worth a lot less in the future. The compounding impact of inflation over time can erode retirement savings.

Figure one uses the example of a retiree with $500,000. An annual inflation rate of 5% would result in their savings running out 10 years sooner than if inflation stayed at 2%. Concerns about inflation and rising costs are top of mind for many pre-retirees. For those already living on a fixed income, the figure is likely to be much greater – as well as eroding the standard of living, it erodes financial certainty.

Inflation not only reduces the future purchasing power of retirement savings, it also introduces the risk that spending needs in the future will be higher than originally planned. This, in turn, may exacerbate the fear of running out of money and increase loss aversion, both common among retirees.

The effect of a rising cost of living affects everyone. Prices for milk, yoghurt and cheese are up almost 15 percent year on year, with bread and cereals up 12 percent[1]. A basket of goods valued at $50 in 2012-13 cost $64.24 in 2022-23, an increase of 28.5 percent[2].

Rising interest rates hit accumulators hard – mortgages, car finance and other forms of debt cost more, sometimes at the expense of voluntary superannuation contributions and other investments.

A significant risk factor is market volatility. The timing of market volatility in a client’s lifecycle can have a significant impact on retirement. A significant capital loss requires a significant gain to get back to the same point. As illustrated in figure two, there is a non-linear relationship between gains and losses; as the loss grows, the gain required to restore the loss escalates.

An investor early in the accumulation phase generally has the advantage of time to recover losses, as well as the opportunity to invest more during market downturns, taking advantage of lower priced assets. Unfortunately, those clients closer to retirement do not generally have this opportunity.

The market conditions that prevail in the years just before and after a person retires can make an enormous difference to how long their funds last. Those crucial years are often called ‘the retirement risk zone’ (figure three), a period when pre and post retirees are most vulnerable to market volatility.

If someone is fortunate enough to retire in a period of upbeat markets, then their income drawdowns will be fully or partially offset by investment returns. However, if the retirement risk zone coincides with a period of negative returns, retirees may start eating into their savings at an accelerated rate, potentially emptying the nest egg[3]. Market shocks during the vulnerable period will leave Australian retirees with less time to recover, while falling asset prices and drawdowns for income can magnify the scale of capital losses. Ultimately, any losses will diminish the total value of the remaining assets available for the decumulation phase.

The accumulation phase lays the groundwork for a secure and comfortable retirement. The more successful this is, the greater certainty – financial and otherwise – your client can have in their post-work years.

The decumulation of assets and spectre of uncertainty

The decumulation phase is a pivotal period that marks the transition to retirement. During this stage, investors start to tap into the assets they’ve accumulated over the years: superannuation, investments and other savings. It’s a time when careful financial planning and budgeting become paramount, as longer, healthier lives mean retirees may need their savings for multi-decades.

The biggest fear voiced by Australians prior to and during retirement is running out of money. This is known as longevity risk – or the risk of outliving one’s retirement savings. With the expectations of a longer life, how much can a retiree afford to draw down each year? For many it’s a dire choice: live more frugally today or risk running out of money tomorrow.

While the Age Pension provides some degree of certainty as a safety net available to all Australians (subject to eligibility requirements) once they reach age 67, it provides only for a basic lifestyle.

The risk factors that influence the value of accumulated assets do not stop having an effect on savings once in retirement – if anything, the influence of each risk factor is magnified.

Inflation continues to erode the long term value of accumulated savings and the rising cost of living can be more challenging to manage on a fixed income. As experienced this year, older Australians are forgoing seeing the doctor or dentist due to the rising cost of those services[4].

On the upside, for those with savings in term deposits or some defensive assets, higher interest rates can be a positive for retirees, particularly those without debts to service.

To mitigate longevity risk, most investors are advised to have an allocation to growth assets. These, of course, are more susceptible to market volatility and can leave investors exposed to sequencing risk as described earlier. The drawing of income or capital from a diminishing pool of assets can magnify the scale of capital losses and erode retirement savings at an accelerated rate. In turn, this increases the likelihood of outliving retirement savings, aka longevity risk.

Growth assets are typically more exposed to the prospects of a market correction, which can have dramatic consequences. As modelled in figure four, the prevailing market conditions at the time of and after retirement can determine how long a retiree’s capital could last when investing in a balanced portfolio.

Because retirees usually can’t align their retirement date with ideal market conditions, the decision to leave work can sometimes be a gamble, particularly without the right advice and an appropriate mix of strategies and products. Unfortunately, sometimes chance can have a much greater impact on retirement outcomes than good planning.

The decumulation phase demands a thoughtful balance between enjoying the fruits of one’s labour and preserving enough capital to meet future expenses and potential unforeseen circumstances. Advisers need to seek solutions that provide for longevity without sacrificing financial flexibility; strategies that incorporate guaranteed lifetime income, market-linked returns, downside protection and the ability to make withdrawals.

With certainty of income and access to capital, retirees can savour their retirement years with certainty and peace of mind, so they can flourish in retirement and enjoy this next well-earned phase of life.

 

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Notes:
[1]  https://www.abc.net.au/news/rural/2023-04-27/steepest-price-increases-for-milk-cheese-in-decades-abs/102268236
[2] Reserve Bank of Australia Inflation Calculator
[3] Allianz Retire+, ‘Talking about sequencing risk’, February 2019
[4] https://www.moneymag.com.au/aussies-skipping-healthcare-as-cost-of-living-bites
This material is issued by Allianz Australia Life Insurance Limited, ABN 27 076 033 782, AFSL 296559 (Allianz Retire+). Allianz Retire+ is a registered business name of Allianz Australia Life Insurance Limited. This information is current and believed to be accurate as at November 2023 unless otherwise specified and contains the current views of Allianz Retire+ which may change in future. This information has been prepared specifically for authorised financial advisers in Australia and is not intended for retail investors. It does not take into account a person’s objectives, financial situation or needs. Before acting on anything contained in this material, you should consider the appropriateness of the information received, having regard to your objectives, financial situation and needs. The tax and social security information in this material sets out our understanding of current legislation and practice as at the date of this document. It is only intended to be general in nature and does not constitute tax or social security advice. We recommend that you seek specific tax and social security financial advice on your personal circumstances before making an investment decision. Allianz Australia Life Insurance Limited is the issuer of AGILE. Prior to making an investment decision, investors should consider the relevant Product Disclosure Statement (PDS) and Target Market Determination (TMD) which are available on our website (www.allianzretireplus.com.au). PIMCO provides investment management and other support services to Allianz Australia Life Insurance Limited but is not responsible for the performance of any Allianz Retire+ product, or any other product or service promoted or supplied by Allianz. Use of the POWERED BY PIMCO trade mark, or any other use of the PIMCO name, is not a recommendation of any particular security, strategy or investment product.

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