CPD: Risk and retirement

What are the risks that retirees face and how do these risks affect the security of their long term retirement funding?

Australian retirees face both controllable and uncontrollable risks that can impact their retirement savings. This article from Allianz Retire+ explores these risks and the potential financial and emotional impacts on your clients.

By 2030, all baby boomers will be 65 or older. Sometimes described as a ‘grey tsunami’, there is no doubt this generation will be one of the largest retired cohorts in history. As this group transitions from accumulation to decumulation over the next decade or so, their investment objectives will change from amassing wealth to generating retirement income to meet their lifestyle goals. Their risk-return objectives will also transition: from ‘maximising returns for a given risk tolerance’ to ‘creating greater certainty of income’.

Unlike many in the generations before them, most baby boomers plan to enjoy an active retirement. Increases in life expectancy and a stronger focus on a healthy, energetic lifestyle will see this cohort engaged in a range of pursuits that might include part time work, voluntary work and participation in a myriad of activities and adventures.

An active life comes with implied costs at a time when the risk-return landscape becomes more complex. A greater focus on using accumulated wealth to sustain a level of income throughout retirement requires careful planning, a meticulous focus on asset allocation to both sustain capital and generate income, as well as risk management.

Of course, not all goes to plan. In 2022-23, the average age at retirement (of all retirees) was 56.9 years, yet the average age people intended to retire was 65.4 years^[1]. Why the difference? Illness, accident, losing a job at an age where finding another is increasingly difficult. This emphasises the importance of retirement planning – and that planning early is critical. Not only does it allow for the unexpected, it can enable clients to better plan for, and manage, the risks their retirement savings may face over the coming years.

Consider the following:

• almost 10% of Australians have retired poor^[2] – although each subsequent generation will have more money in super, for many baby boomers compulsory super was introduced partway through their working lives. As such, the median balance is around $205,000 (less for women)^[3]
• financial challenges for retirees are increasing alongside the need to fund more years in retirement
• retirees find it extremely difficult to manage savings over an unknown period of time as factors such as sequencing risk, market volatility and inflation introduce extreme uncertainty into long term planning
• increased uncertainty due to the geopolitical environment and US economic policy will most likely impact financial markets over the coming years.

It is critical to educate clients about potential risks before they retire. Each client should understand the potential risks they may face and the implications for both their retirement income and lifestyle.

Risks in retirement

Certain risks come with a level of control for most individuals. These include the timing of retirement, the amount saved and the rate of withdrawal once retired. Both you and your client can influence these factors. However, unexpected events may lead to early retirement, while unforeseen financial challenges can limit the funds available.

On the other hand, some risks are beyond control. These ‘uncontrollable’ risks are often interconnected and can have long-term effects on your client. Whether individually or collectively, they may impact investment risk tolerance, force reduced spending or require difficult lifestyle adjustments.

Controllable risks

Certain retirement risks are often labelled ‘controllable,’ although that may not always be the case. Unforeseen events can disrupt even the most carefully laid plans, making personal insurance a crucial safety net – especially for those forced into early retirement due to illness or an accident.

Consider retirement timing. Ideally, your client will choose their preferred retirement age and, with your guidance, transition to retirement accordingly. However, as outlined earlier in this article, many Australians retired earlier than expected: health issues, accidents, caregiving responsibilities, job loss, or business failure can all precipitate an earlier than expected retirement event.

An unplanned transition into retirement can create uncertainty, leaving individuals feeling anxious and financially unprepared. Beyond the emotional toll, unexpected early retirement can upend financial plans – eliminating a stable salary and leaving retirees vulnerable to market fluctuations. This underscores the importance of early retirement planning, as unforeseen circumstances may accelerate a client’s retirement timeline and leave them less equipped for long-term financial security.

Another so-called controllable risk is the amount of retirement savings, with increased contributions often seen as a way to mitigate the risk of running out of funds. While a sound strategy in principle, increasing contributions is not always feasible. Increasingly, older Australians are retiring with mortgage debt or using their savings to support family members (the bank of mum and dad). Additionally, the same factors that influence retirement timing – such as job loss or health issues – can also limit a person’s ability to contribute more. Despite these challenges, retirement planning should prioritise strategies to boost savings as early as possible, as even small increases in contributions can yield long-term benefits.

A third factor often considered controllable is the withdrawal rate. The faster retirement savings are drawn down, the sooner they may be depleted. This can impact a client’s ability to meet essential needs, maintain their lifestyle and safeguard their overall well-being. However, mandatory minimum drawdown requirements must be met, and personal circumstances can shift over time, affecting both retirement strategies and the longevity of savings.

Uncontrollable risks

Given the uncertainty of life and death, it’s impossible to work out precisely how much retirees can afford to draw down each year. Instead, many retirees face a tough decision: should they live more frugally, or risk running out of money?

The additional uncertainty around future investment returns throws a further complication into the mix.

Australians cannot plan their retirement based on recent or contemporary market movements as they need to account for unknowable future market returns. The current global environment has a plethora of challenges for markets – the impacts of US tariffs on markets, inflation and rates; geopolitical forces and the impacts on financial markets; political changes worldwide and how changing policies could impact the economic environment both within individual nations and worldwide.

As highlighted by the Retirement Income Review, Australian retirees are dangerously exposed to longevity risk – the risk of outliving their savings. This risk, the ‘fear of running out’ (FORO) is one that’s particularly anxiety provoking for many older Australians. In turn, longevity risk – or the longevity of retirement savings – is affected by several other key risks, namely:

Sequencing risk

The market conditions that prevail in the seven to ten years before and after retirement can make an enormous difference to how long their funds last. Those crucial years are often called ‘the retirement risk zone’ (see figure one). It is during this period that a severe market downturn could be most detrimental.

If a client is fortunate enough to retire in a period of positive markets, their income drawdowns will be fully or partially offset by investment returns. This is an ideal scenario.

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^[4]. 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.

Retirees have no control over the sequence of returns; in other words, on the order of years with positive or negative returns. In a perfect world, Australians would retire only during periods of reduced volatility when their investment outcomes can be planned for with a greater deal of certainty.

Market risk

The GFC, which saw the ASX 200 lose roughly 54 percent of its value between 2007 and 2009, scared many Australian retirees. Research by National Seniors Australia carried out a decade after the crisis found 72 percent of retirees were afraid they would face a similar crash in their lifetime^[5].

More than half (59 percent) said they would not be able to tolerate a crash of that magnitude. In 2020, many came close to experiencing a GFC-like event. As the Covid-19 pandemic spread across the globe, markets reacted violently with the ASX 200 index losing 35 percent of its value between 20 February and 23 March.^[6] Markets have since bounced back to record new highs; however, the risk of exogenous shock is heightened in the current geopolitical environment.

The timing, as well as the size, of a crash can have dramatic consequences for the retired. As modelled in figure two, 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. It was chance that dealt 1982’s retirees buoyant markets, and chance that presented 1929’s retirees with a market crash and rapid capital depletion.

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

A significant capital loss requires a significant gain to get back to the same point. As illustrated in figure three, there is a nonlinear relationship between gains and losses; as the loss grows, the gain required to restore the loss escalates.

Clients in the accumulation phase generally have 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, a retiree in decumulation phase does not usually have this opportunity.

Inflation risk

Inflation risk has been making headlines and been top of mind for several years now. Although it’s largely ‘under control’ in most markets, some of the political decisions being made overseas risk its resurgence. For example, the tariffs being imposed by President Trump will be inflationary. Even if that inflationary affect is confined to the United States, the impact on its financial markets can have worldwide effects.

The compounding impact of inflation over time can erode retirement savings. Figure four uses the example of a retiree with $500,000. An annual inflation rate of five percent would result in their savings running out 10 years sooner than if inflation stayed at two percent. Concerns about inflation and rising costs are top of mind for many pre-retirees; for those already living on a fixed retirement income, the impact is likely to be much greater.

Higher inflation reduces purchasing power and introduces the risk that a retiree’s 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. A 2024 Investment Trends report cited their research found retirement confidence had dropped to a 10-year low last year, with 47 percent of pre-retirees feeling unprepared for retirement as cost of living pressure continues to mount^[7].

These concerns can also lead to an overly conservative mindset toward both investing and spending.

Behavioural Risk

Sometimes referred to as ‘loss aversion risk’, behavioural risk can impact how a retiree invests, how much income they draw and what sort of lifestyle they adopt. A range of behavioural studies have illustrated traits and biases that can impede your clients from making reasonable decisions about their retirement savings.

These biases might stem from others’ experiences, the fear of outliving their savings or the fear of losing capital. An earlier research report from Investment Trends^[8] identified three retirement fears that remain pertinent in the current environment.

While loss aversion is a major factor influencing investor behaviour, particularly in retirement when it’s difficult to recoup losses, understanding other biases and fears that may negatively impact your clients’ decision making is essential to retirement planning.

Conservatism Risk

Linked to behavioural risk, being hyper-conservative can influence both investment and spending decisions in retirement. Some retirees adopt an overly defensive stance to investments, shifting substantial portions of their portfolios into cash and term deposits. This cautious approach can pose a significant behavioural risk and increase the likelihood of panic-selling growth assets during market downturns.

While many retirees may be willing to reduce the probability of negative returns at the expense of upside potential, they also need to understand the potential long-term ramifications of reducing exposure to growth assets.

Expect the unexpected

There is always the risk of unexpected expenses. As Cyclone Alfred bears down on south-east Queensland, retirees in its path may be spending money on protecting their home and other assets. In the aftermath, they may need home repairs they would not have anticipated a week or two ago. Others face unforeseen health-related expenses or the need to support children or grandchildren to experience economic hardship.

Divorce can also stretch retirement budgets in unexpected ways. Financial consequences include the potential for legal fees to eat into retirement savings, the need to split retirement savings, and the loss of being able to share expenses, which makes life more costly for single retirees.

Retirement risks are interconnected. Market volatility contributes to both market and sequencing risk, while inflation can trigger and exacerbate these challenges. Inflation also heightens longevity risk and influences retirees’ behaviour, making them more loss-averse or encouraging more frugal spending. While education can help clients navigate these risks, strategic portfolio construction also plays a key role in managing them – either partially or entirely.

Building a well-structured retirement portfolio is complex, as retirees require a balance of capital, income and the flexibility to adapt to changing circumstances. One effective strategy is to incorporate both capital protected and guaranteed income products. Capital protected products help mitigate market risk, preserve principal and provide a steady income source. Guaranteed income products offer a reliable income stream throughout retirement. By combining these elements, advisers can create diversified retirement portfolios that effectively balance risk and reward, ensuring greater financial security and peace of mind for retirees.

The financial services industry now has a significant opportunity to enhance retirement strategies in ways that could dramatically improve both the financial wellbeing and emotional health of retirees. Companies that develop tailored solutions – focused on flexible, guaranteed lifetime income while maintaining access to capital – will set the standard in shaping the future of retirement planning.

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Notes:
[1] ABS, Retirement and Retirement Intentions Australia, May 2024
[2] B Coates, T Chen, ‘Why Australia’s old-age poverty rates are far lower than you might think’, Grattan Institute, 10 April 2019
[3] ASFA, An update on superannuation account balances, September 2024
[4] Allianz Retire+, ‘Talking about sequencing risk’, February 2019
[5] National Seniors Australia, ‘Once bitten twice shy: GFC concerns linger for Australian seniors’, July 2018
[6] C Johnson, K Lane, N McClure, ‘Australian securities markets through the COVID-19 pandemic’, Reserve Bank of Australia, 17 March 2022
[7] Investment Trends, 2024 Retirement Income Report, October 2024
[8] Investment Trends, 2022 Retirement Income Report, October 2022