Sequencing risk can interact with, and exacerbate, a range of other risk factors to challenge retirement plans.

It’s estimated that 670,000 Australians intend to retire between now and 2028^[1]. As this cohort approaches retirement, they’re in the ‘retirement risk zone’ where volatile markets can make or break their retirement plans. In this article, proudly sponsored by Allianz Retire+, sequencing risk and its impact on other risk factors is put under the microscope.

It’s not new news that Australians are living longer, healthier lives and enjoy a more active lifestyle than their parents and grandparents. For those who retired during a bull market, retirement can be a succession of halcyon days enjoying all that life has to offer. However, for those who experience volatile markets in the lead up to and early days of retirement, it can be quite a different story, one beset by anxiety and fear.

Defining sequencing risk

In retirement, market volatility can have a major impact on how long your clients’ savings last and how long they can live a comfortable lifestyle. At its simplest, sequencing risk can be described as the risk that the order and timing of your client’s investment returns are unfavourable, resulting in less money for their retirement.

Unfortunately, retirees have no control over the sequence of returns. Ideally, Australians would only retire during periods of reduced volatility when their investment outcomes can be planned for with a greater deal of certainty!

The order, or sequence, in which investment returns occur becomes crucial in the lead up to retirement. If a portfolio sustains significant losses early on, it can have a lasting and detrimental impact on the overall wealth and sustainability of the portfolio.

In fact, the market conditions that prevail in the seven years just before and after a client retires can make an enormous difference to how long their funds last. Those crucial years are often called ‘the retirement risk zone’ (see figure one); a period when retirees are most vulnerable to market volatility. This is when clients’ savings are at their highest, but also when they are most vulnerable to market shocks and volatility.

If a client 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.

Market shocks during the most vulnerable period will leave retirees with less time to recover, while falling asset prices and drawdowns for income or capital can magnify the scale of capital losses. Ultimately, any losses will diminish the total value of the remaining assets.

Market shocks and sequencing risk

A large decrease in the value of a client’s portfolio can arise from a market shock. The timing of this shock in an investor’s lifecycle can have a significant impact on retirement and affect the longevity of investor’s capital.

Market risk is exacerbated when multiple asset classes experience significant loss. A significant capital loss requires a significant gain to get back to the same point. As illustrated in figure two, 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 and benefit from dollar cost averaging. Unfortunately, a retiree in decumulation phase does not generally have this opportunity and, when this happens in early retirement, the effect can be disastrous.

The timing and size of a market correction can have substantial consequences to retirement savings. As illustrated in figure three, 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 crash and rapid capital depletion.

The impact of sequencing risk on the other retirement risks

There are a range of risks that impact retirement…after all, no one knows how long they’ll live for, how the cost of living might impact lifestyle choices or the funding requirements they may have in the future. Typically as retirees age, a greater focus (and proportion of expenditure) is given to meeting health care and aged care needs which are, in most cases, unpredictable.

In the event of market volatility during the retirement risk zone, the impact of these risk factors is exacerbated and likely to have a much greater impact on the client’s retirement than if they retired during a period of market buoyancy.

Longevity risk

Australians dying with sizeable super balances is often spruiked by the media as resulting from a bequest motive, to transfer that remaining wealth to the next generation. However, an AFSA study^[2] found that the majority of people exhaust all of their superannuation well before their death, with a small proportion passing on some superannuation to their spouse and a smaller proportion again bequeathing it to children or grandchildren.

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 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 simply plan their retirement based on contemporary market movements as they need to account for unknowable changes in returns.

A survey of pre-retirement age Australians in 2022^[3] found 47 percent expected to outlive their super and most respondents expected they would not reach their desired retirement income level. Consequently, many retirees ‘self-insure’ against longevity risk by living more frugally than they’d likely anticipated, in an attempt to preserve their super or other savings for as long as possible.

Sequencing risk heightens longevity risk; a poor sequence of returns during the ‘retirement risk zone’ is more likely to result in faster consumption of retirement savings, particularly in situations where capital protection strategies are not employed prior to entering that risk zone.

Inflation risk

Inflation risk has been top of mind for all Australians as the cost of living continues to spiral. A basket of goods and services that cost $100 in financial year 2017/18 would now cost $117.01, an increase of 17 percent over five years^[5]. Many other services, such as health care, have increased well past the rate of inflation. A recent study by National Seniors Australia^[6] suggests 68 percent of older people have recently gone without or hesitated to access essential healthcare because of cost.

Higher inflation can reduce retirees’ purchasing power and 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.

The compounding impact of inflation over time can erode retirement savings. Figure four draws on an 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 remained at two percent. Inflation combined with sequencing risk is a double-edged sword, as the two forces combine to hasten the erosion of retirement savings.

Behavioural risk – or ‘loss aversion’

As retirement savings are eroded by market forces, it’s not uncommon for clients to experience loss aversion.

Loss aversion is a psychological phenomenon that refers to the tendency of individuals to feel the pain of losses more intensely than any pleasure derived from equivalent gains. For retirees reliant on their accumulated savings and investments to fund their post-employment years, market fluctuations can trigger heightened anxiety and emotional distress.

The fear of losing a significant portion of their nest egg during periods of market turbulence can lead retirees to make hasty and potentially detrimental financial decisions, such as selling investments at a loss or shifting to overly conservative portfolios. This aversion to losses may result in missed opportunities for market recovery and can have lasting consequences on the sustainability of their retirement funds.

Financial advisers must be attuned to this behavioural bias, employing strategies that balance risk and reward while helping retirees navigate the emotional challenges associated with market volatility.  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. Research from Investment Trends, although a year old, identified three retirement fears (figure five) 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.

Given the prevalence of these risks it’s no surprise that funding post-work lifestyles is a cause of stress for Australians close to retirement. Health authorities note that worries relating to money are a leading source of stress in Australia and can lead to depression and anxiety^[8], compounding the health issues many retirees face as they age.

The interconnected nature of retirement risks underscores the complexity faced by retirees, and advisers, in safeguarding their financial wellbeing. At the centre of this is sequencing risk where the timing of market fluctuations can significantly impact the sustainability of a retiree’s portfolio.

Amid this delicate dance of risk, inflation emerges as a pervasive catalyst, influencing both market dynamics and retiree behaviour. The erosive effects of inflation on purchasing power not only pose a threat to financial security but can also amplify longevity risk, as retirees may need to fund an extended retirement period.

Furthermore, the insidious nature of inflation can shape retiree behaviour, fostering a heightened sense of loss aversion and prompting more frugal living habits as individuals seek to preserve their diminishing purchasing power.

While prudent planning and financial education can help mitigate some of these risks, it’s crucial to acknowledge that external factors, such as sequencing risk, market fluctuations and inflation rates remain largely beyond an individual’s control, necessitating a thoughtful and adaptable approach to retirement planning.

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Notes:
[1] ABS, Retirement and Retirement Intentions Australia, August 2023
[2] Diagrams and examples in this document are not exhaustive. The data, assumptions and outcomes shown are hypothetical and designed to illustrate the product concept. They are not reflective of real life examples and should not be relied on as indicative of any actual product performance, capital or income return.
[3] ASFA, Superannuation balances prior to death:  Superannuation balances of older Australians, March 2021
[4] Investment Trends, 2022 Retirement Income Report, October 2022
[5] RBA inflation calculator at.rba.gov.au/calculator – accessed 19 November 2023
[6] National Seniors Australia, Older People’s Experiences of Healthcare Affordability and Accessibility, August 2023
[7] Diagrams and examples in this document are not exhaustive. The data, assumptions and outcomes shown are hypothetical and designed to illustrate the product concept. They are not reflective of real life examples and should not be relied on as indicative of any actual product performance, capital or income return.
[8] Health Direct, ‘Financial stress and your health’, December 2020

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Whatever the decisions made about funding retirement, what is certain is the need for more innovative solutions in the decumulation phase.

Between now and 2028, 670,000 Australians intend to retire, taking the total number to almost five million^[1]. As our total population ages, what does that mean for the future of retirement? In this article, proudly sponsored by Allianz Retire+, Australia’s current and future retirement landscapes are examined.

Australians are experiencing a major societal transformation that has resulted in people living longer, healthier lives. Retirees today also tend to enjoy a more active lifestyle than any previous generation.

The enormous gains in quality and quantity of life, however, come with an implied financial cost that requires retirees to stretch their savings over multi-decade timeframes that will include unpredictable market conditions and personal challenges.

Years ago, a ‘set and forget’ approach to retirement planning may have been all that was needed to enjoy a comfortable lifestyle. But times have changed…Australia’s demographic composition is ageing, the cost of living is rising, and volatility remains an ever-present challenge. What will retirement look like in the future?

Looking forward

As well as living longer, Australians will spend more years in full health and more time using government-funded services according to the Intergenerational Report 2023. Increased longevity and low fertility rates mean the population will continue to age over the next 40 years. The number of people aged 65 and over will more than double and the number aged 85 and over will more than triple. Population ageing will be an ongoing economic and fiscal challenge for governments^[2].

One of the largest impacts of the ageing population is the old-age dependency ratio, which is the ratio of older dependents – people aged 64 plus – to the working-age population, those aged 15-64. The Intergenerational Report estimates that between 2022–23 and 2062–63, the old-age dependency ratio is expected to increase from 26.6 percent to 38.2 percent.

This change indicates that the size of the population aged 65 plus will grow faster than the working age population. It also highlights that there will be greater pressure on the tax base to fund those services needed by an ageing population – welfare payments such as the Age Pension, in-home care, aged care and health care. Accordingly, demographic change is expected to affect major government payments as the share of older people in the population increases.

Superannuation

As the superannuation system matures, a greater share of superannuation assets will be held by retirees who will draw down on this capital to fund their retirement. As balances increase, superannuation will become the primary source of retirement income for many future retirees^[3].

The previous Intergenerational Report (2021) estimated that with 12 percent superannuation guarantee contributions (SGC) by 2025, the median superannuation balance at retirement will increase from around $125,000 in 2020-21 to around $460,000 in 2060-61 in today’s dollars.

The development of super funds’ strategies to assist their members to maximise retirement income, manage longevity risk and provide access to capital under the Retirement Income Covenant will become more critical as Australians age, as will the availability of retirement products that can deliver on these objectives.

The Age Pension

The total number of Australians of Age Pension age and over is expected to roughly double to around nine million by 2062-63. However, it is expected that a smaller proportion of this cohort will receive an Australian government pension or other income support payment declining by around 15 percentage points by 2062–63 (figure one)^[4].

This change is anticipated to result from a shift towards a greater reliance on superannuation as a key source of retirement income; the SGC will be expected to do the heavy lifting to reduce reliance on the Age Pension. So, instead of being the primary source of retirement income, the Age Pension is expected to increasingly be used to supplement retirement income.

These forecasts suggest a retirement landscape in which the majority of Australians will have had a longer time period over which to accumulate superannuation assets and be better able to provide for their retirement needs. While our super system is well geared up for the accumulation phase, the realisation of this forecast will be reliant on having the right decumulation products to provide for retirement needs: income for life, access to capital, the ability to ride out volatile markets.

The present

Around the same time that Treasury released its Intergenerational Report 2023, the Australian Bureau of Statistics (ABS) released its 2020-21 Retirement and Retirement Intentions statistical report.

During this period there were 4.1 million retirees in Australia. In 2020, 140,000 people retired, with an average age of 64.3 years. Around 670,000 people intend to retire in the next five years, with an expected 220,000 retirements over the next two years.

The average age people intend to retire is 65.5 years, yet across all retirees, the average age at retirement was 56.3 years. For people intending to retire, the main factor that will influence timing is financial security. However, the best of plans can go awry. Unanticipated events that lead to early retirement can explain the discrepancy between intentions and reality (figure two). In 2020-21, the top three reasons for retirement were:

• Reached retirement age or eligible for superannuation (28 percent)
• Sickness, injury or disability (13 percent)
• Retrenched, dismissed or no work available (7 percent).

In addition, six percent left their last job to care for an ill, disabled or elderly person; four percent women, two percent men^[5].

That’s 26 percent of Australians who have to involuntarily leave the workforce, possibly before they had finished saving for retirement. An unexpected illness, injury or job loss can derail the best laid of retirement plans. The propensity for a proportion of the ageing cohort to retire earlier than intended is likely to continue into the future and should be considered as part of retirement planning.

That the majority of retirees rely on the Age Pension for retirement income is not surprising; most of Australia’s current cohort of retirees missed out on superannuation in their early years and when the SGC was introduced in 1992, it was just three percent. Less time to accumulate a retirement nest egg and few fit for purpose products to provide income in the decumulation phase means the Age Pension safety net is critical for many.

Fortunately, as outlined in the Intergenerational Report 2023, receiving super contributions over a longer time period, and at a higher rate, will better support retirement in the future.

The value of advice

Approximately 2,700 Australians retire every day. Some of them will enter retirement confident about their future, many will not. The advice opportunity is significant.

Financial advice can play a pivotal role in securing a comfortable and stress-free retirement. The complex landscape of retirement planning, with its need for accumulation and decumulation, changing tax implications and a myriad of risk factors can be overwhelming, even for financially savvy individuals.

Retirement advice helps navigate these intricacies. Taking into account risk tolerance, the client’s financial situation and long-term goals enables allows the retiree – or prospective retiree – to feel confident in their future. It’s also an opportunity to help individuals stay abreast of changing economic conditions and market volatility, to ensure that their retirement plan remains adaptable and optimised over time.

Importantly, with an adviser’s guidance, retirees can feel confident that their financial future is in safe hands; this security allows the client to enjoy their ‘golden years’ without the spectre of financial uncertainty disturbing their peace.

Research has found that prospective retirees are more likely than current retirees to worry about having a good quality of life in retirement, are worried about making ends meet, feel that they don’t know enough about personal finance and in some cases, are too embarrassed to ask for financial advice^[6].

The same study discovered that seven in ten of those who have financial advisers feel in control, confident and secure in their financial position. These individuals are also less likely to worry about whether they will have a good quality of life in retirement compared to those who don’t have an adviser, highlighting both the value and importance of retirement advice.

Interestingly, prospective retirees are, overall, more worried than current retirees about many issues, notably medical bills and not having the savings to live the life they want to in retirement; this speaks to a fear of the unknown that faces Australians as they head into retirement (figure four).

Aged care

Australia’s aged care system provides subsidised support and care to older Australians. Most Australians who reach old age will need aged care services^[7]. The major aged care services subsidised by the Australian Government include:

• basic in-home care services through the Commonwealth Home Support Programme
• four levels of in-home care services through Home Care Packages
• residential aged care services that provide care and accommodation for older people who are unable to live in their own home.

Aged care funding accounts for around 70 percent of the projected increase in government spending on aged care per person; as stated in the Intergenerational Report, additional future demand for aged care will require funding approaches that support a “fair and equitable” aged care system. This has excited media interest: will it result in a ‘boomer tax’ on the home or requirements that an amount of superannuation is ring-fenced to meet any aged care costs that arise?

Advice relating to aged care is also important. It empowers individuals – and their families – to navigate the complex landscape of aged care services with confidence and foresight.

Ageing brings forth a multitude of considerations, from healthcare needs to financial planning for long-term care. Retirees need to be in a position to make informed decisions that align with their preferences, health conditions and financial resources.

By including aged care advice as part of the retirement planning process, individuals can plan for their evolving needs, which can enable them to maintain independence, dignity and a better quality of life well into their senior years. This can have a positive affect on their physical, emotional and financial well-being.

Despite this, only 27 percent of current and prospective retirees have a plan to pay for aged care, despite approximately half of respondents preferring this option (figure five). Of those who don’t plan to go into aged care or do not know if they could afford it, 90 percent do not have a financial adviser.

Whatever the decisions made about funding retirement and its attendant care regimes, what is certain is the need for more innovative solutions in the decumulation phase. Such solutions must provide for longevity without sacrificing financial flexibility. Retirement strategies need to incorporate a more comprehensive suite of features including guaranteed lifetime income, market-linked returns, downside protection and the ability to make withdrawals.

The next generation of retirement income products need to help Australians make informed and confident spending decisions so they can flourish in retirement and enjoy this next well-earned phase of life.

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Notes:
[1] ABS, Retirement and Retirement Intentions Australia, August 2023
[2] Australian Treasury. Intergenerational Report 2023, August 2023
[3] Ibid.
[4] Ibid.
[5] ABS, Retirement and Retirement Intentions 2020-2021, August 2023
[6] Allianz, Fiftyfive5 research, July 2021
[7] Australian Treasury, Intergenerational Report 2023, August 2023

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