The idea of an ‘average’ retiree is a myth – so why base a financial plan on average life expectancies and returns?
It used to be that retirement was all about winding down and playing lawn bowls. But today, retirees are enjoying a more active and diverse retirement, shunning bowls for martial arts. Dating in retirement is up. And while some are enjoying a slower, gentler approach to life, others are using their free time to get more active.
It’s clear that retirees are not a homogeneous group, but individuals with their own interests, goals and aspirations. But they do have a few things in common. One is a longer life expectancy than their parents and grandparents.
The ‘average’ retiree
Of couples aged 65 years old right now, there’s a 7% chance at least one of them will live to 1001. If you factor in future mortality improvements, this increases to 10%.
So if you have 150 clients in your practice going into retirement, 10 to 15 of them will likely live to 100 – spending at least 35 years in retirement.
We also know that there’s a strong correlation between life expectancy and income – especially for men2. So it’s likely that your clients with most money will need to make their wealth last the longest.
But of course, planning for retirement portfolios is far more complex than estimating someone’s life span based on statistics. Each retiree is different: from their general health and activity level to their lifestyle goals and expectations.
So why do we still try to create retirement plans based on average life expectancies and returns?
We’ve all seen the simple drawdown graphs that super retirement calculators produce. Let’s imagine we’ve created one for a $300,000 portfolio, with a drawdown of 5%, indexed to inflation to calculate its average returns over time.
Because it’s based on averages, there is a 50% chance the portfolio will last 41 years or more. But there’s also a 50% chance it will run out before then3.
In other words, 50% of the clients relying on this portfolio risk outliving their retirement funds.
Retirement and sequencing risk
Another danger of using averages to calculate a retirement portfolio is that it ignores sequencing risk – which can be devastating during retirement. For example, two investors whose portfolios have identical average returns – but experience losses at different times – will experience different impacts on their retirement savings.
One investor experiences a strong market downturn during their accumulation years. But, because they have time to make up the losses, it won’t make a big difference to their retirement.
The other investor is close to retirement when the downturn impacts their portfolio. In this case, they have less time to recoup losses before starting to draw down on their savings – increasing the risk their money will run out early on. Even if investor one experiences lower returns in retirement phase, their retirement will still be impacted less than investor two.
Here’s an illustration of how this might work:
Two investors each had $500,000 when they retired. One retired during the 1929 market crash – the other in 1982. The investor who retired in 1929 would have run out of money in just 20 years. But the investor who retired in 1982 would have still a portfolio worth $2 million after 27 years – even if they drew down 5% each year4.
What worries most retirees is that their portfolio is going to act like the one from 1929. And considering the current state of the markets in the wake of COVID-19, that’s not an unreasonable fear to have.
A better approach
If we really want to help our clients, we need to stop talking about averages. Retirees don’t want 50–50 odds. They want to know that there’s a high chance that their money will last through their retirement. This could mean moving them to a more conservative portfolio. But the problem is, while it may perform better in a worse-case scenario, it won’t do so well in better times.
To really help clients, we need to maximise those good years – but not at the expense of reducing their returns during the worst-case scenario. A retirement-specific product, like Future Safe – which is linked to share market returns with a ‘cap’ that is determined by the ‘floor’ you choose, designed to limit loss during a market downturn – can be helpful in managing retirement risk. It can help give your clients more certainty that they’ll have the money to have the retirement they hoped for – even when things go wrong.
Facing uncertainty with confidence
As the impact of COVID-19 creates havoc for sharemarkets, advisers need to provide even more support and reassurance for clients in or approaching retirement. By creating a plan based on their particular needs, with accurate forecasts for best and worst scenarios, you can help them face their retirement with confidence.
1 Australian Life Tables 2015-17
2 The Association Between Income and Life Expectancy in the United States, 2001-2014, Raj Chetty, PhD; Michael Stepner, BA; Sarah Abraham, BA; Shelby Lin, MPhil; Benjamin Scuderi, BA; Nicholas Turner, PhD; Augustin Bergeron, MA; David Cutler, PhD.
3 The portfolios represent the 50th percentile of the 5,000 portfolio simulations conducted by Milliman. It assumes a starting balance of $300,000 and a 5% withdrawal rate (indexed to inflation). The calculations are based on various portfolio allocation and financial assumptions that are predictive in nature. The outcomes actually achieved may differ materially from these projections. Past performance is not a reliable indicator of future performance.
4 Source: Wealth Benchmarks. $500,000 invested in a diversified, multi-sector 60/40 balanced portfolio – rebalanced annually. Drawdown equal to 5% of starting balance indexed to inflation at a rate of 3%