I like to conceptualize! Every time one of my clients retires, I like to picture the accumulated retirement savings of that couple waking up to an early morning alarm, getting dressed, and going to work on behalf of them. When you think about it, that’s precisely what happens. For the entirety of one’s working life, their living costs are met from their physical exertion, in getting up and going to work. In fact, retirement savings are boosted by the worker’s act of waking up and going to work, in the form of employer superannuation contributions and the worker’s salary sacrifice contributions. All of that abruptly changes when the worker retires. Not only do contributions cease (no more employer super or salary sacrifice going in), but money starts to come out to meet the living costs of the newly retired.
You don’t want your money to be a part-time worker! When you stop working, your money needs to work even harder for you. For a retired couple in 2018, it’s a common starting point to need to draw between $60,000 – $70,000 pa. from their retirement savings. If your money isn’t working hard enough for you, and is only generating a return of $30,000 pa. for example, then you are going to go backwards reasonably quickly. This is no different to when you are working – if you consistently spend more than you earn each year it is going to lead to financial problems. The misconception that many aspiring retirees subscribe to is that they need to move their money into “safer” investments as they approach retirement. This generally means moving more of their retirement savings out of higher-returning, higher-volatility investments (think Australian and Global companies) and into lower-returning, lower-volatility deposit style investments (think bank term deposits). The problem with this is that the return rates of term deposits at circa 2.5% – 3% means that even if they have $1,000,000 of retirement savings, this money is only earning an income of between $25,000 – $30,000 per year for them assuming that it is fully allocated to term deposits. In other words, their money is a part-time worker!
The main issue with money working part-time for you is that it simply runs out too quickly. Let’s use the $1,000,000 retirement savings example, earning a 3% assumed rate of return with the retiree drawing $70,000 pa. of income. After the first year of being retired, the retiree has a reduced retirement savings of only $960,000 ($1million + $30,000 – income drawn $70,000). So begins a slippery slope where the 3% rate of return in the 2nd year now only yields $28,800 (instead of $30,000). Assuming the retiree draws an increased income of $72,000 as the cost of living increases, now the retiree has only $916,800 by start of their 3rd year of being retired. This continues to compound… each year the rate of return in dollars decreases, and the income required to be drawn to meet the increased cost of living increases. This culminates in the retirees having completely exhausted their retirement savings somewhere in the 15th year of their retirement… in other words, they have run out of money.
Your money needs to be working full-time for you! By putting your money to work harder, and targeting a higher return of say 8% pa., your money is now starting to generate a rate of return that would allow the average retiree to have a much higher chance of not running out of money prematurely. Using the same example of $1,000,000 of retirement savings, an 8% rate of return generates $80,000 from which the retirees take an income of $70,000 in the first year of their retirement… Their fund grows to $1,010,000 ($1million + $80,000 – income drawn $70,000) by the beginning of their 2nd year in retirement. This leads to a much better financial outcome as the income drawn is less than the rate of return.
What happens when my money gets injured and can’t go to work for me? One could think of a market downturn (eg. think decline of -30% for Australian and Global companies share prices) as a period of time when your money is injured and can no longer work for you. Whilst this may be an appropriate analogy, market declines are temporary, usually short-lived, and have always recovered. This means that whilst your money isn’t pulling it’s weight for a period of time, this period of time inevitably ends and your money goes back to work for you full time. Ideally, you would want to mitigate the negative effect of this by having a contingency plan in place. The best insurance that we know of is to have a portion (usually 5% – 15% of your overall retirement savings balance) of your retirement savings invested into bank term deposit style accounts that can be called upon in times when the growth markets are temporarily moving backwards. This is akin to having an “income protection” insurance policy for your hard-working money!
The generation of folks retiring today face a far lengthier retirement than did previous generations. Whilst needing to have a suitable contingency plan in place to combat volatility, the reality is that the vast majority of retires will need to have their money working full-time for them in order to fund their longer retirement.
Written by Michael Hogue.
Dallas Davison, Michael Hogue and Ali Hogue.