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The case for equities in retirement

Conventional wisdom suggests that as you approach retirement you should move your savings into conservative, income-producing investments rather than leaving them in growth assets. Indeed there is merit in constantly reviewing your mix of assets but the average life expectancy of a male retiring at age 65 is around 18.5 years and a female 21.5 years. In fact, around 1 in 4 men retiring at age 65 will live at least another 25 years (to age 90), while 1 in 3 women will live past that milestone.

Many retirees’ greatest financial risk will be outliving their savings and having to rely on an unpredictable public pension. This paper illustrates that if they can live with the added volatility, retirees may be better off maintaining a significant allocation to growth assets, in particular shares, rather than switching wholly to more conservative asset classes such as cash, bonds or annuities.

Long term performance of equities and fixed income

Shares are well known to offer the potential for higher returns than more stable asset classes, offset by the likelihood of higher volatility. This has been the historical experience. Chart 1 shows that the average nominal equity return over 110 years was 11.7% compared with bonds 5.3% and bills 4.6%.

Chart 1: Long term performance of different Australian asset classes 1900-2010

AIM Chart1 101014

AIM Chart1 101014

Source: Elroy Dimson, Paul Marsh and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2010. Past performance is not a reliable indicator of future performance.

Shares as an inflation hedge

Australian shares have been one of the better inflation hedges over long periods of time. Chart 2 shows the rolling performance of Australian shares measured over 10 year periods. Over all rolling 10 year periods since 1980, shares have delivered positive returns and have outperformed inflation.

Chart 2: Rolling 10 year performance of Australian shares versus in?ation (CPI)

AIM Chart2 101014Source: Iress (XAOAI, ACPI).

The back data for the bond market indices is more limited, but Chart 3 shows 10 year rolling performance of Australian shares relative to Australian bonds (Australian Composite Index). Over most periods, shares have been superior. We note however that bonds are likely to have done better than shares for a period prior to the commencement of this chart due to the compression in bond yields that took place in the late 1980s, combined with the poor performance of shares due to the crash of 1987. But over the 101 years to 2001, shares have been a better in?ation hedge than bonds as real returns, on average, have been better for shares than bonds.

Chart 3: Rolling 10 year performance of Australian shares and Australian bonds

AIM Chart3 101014Source: Iress (XAOAI, SCPALL).

Can shares provide an adequate stream of income?

Dividends, while they have been volatile at times, have generally grown at a faster pace than living costs measured by CPI. Chart 4 excludes franking credits which are a cash benefit for Australian residents investing in Australian shares on top of income growth and capital return. When living off a combination of capital and income, an equity portfolio can serve investors well.

Chart 4: Dividend income, dividend yield and CPI (1980-2013)

AIM Chart4 101014Source: Iress (XAOAI, ACPI).

The Association of Superannuation Funds of Australia (ASFA) has suggested that a couple currently needs $57,665 per annum to retire with a comfortable lifestyle. We estimate that to avoid reliance on a pension for at least 25 years, a retiree will need a current starting balance of at least $1,043,794 (assumes 2.5% in?ation and 5% investment return per annum. No income tax is included). To consider whether an equity portfolio can support retirement, we have modelled equity funds for 25 year retirement periods starting in each years from 1965 to 1989 (1989 is 25 years ago) and for partial periods from 1990 to 2007 with full allocation to equities at the start.

In our analysis, we use the ASFA starting balance and retirement income stream noted above, instead of discounting both numbers back to the start of each retirement period. This effectively scales the starting capital and income requirements equally, such that the dollar values are more comparable between retirement years. In years where the dividend stream does not provide the required in?ation-adjusted income stream, shares are sold to meet that income objective. Essentially, if you didn’t run out of capital, you met your retirement income requirements. Our analysis shows that in many cases your estate would have ended up with far in excess of your starting capital, allowing you to leave a financial legacy for your family.

In Chart 5 below, we look at some of the retirement outcomes that generate both large positive and large negative capital outcomes. There are some outcomes where the initial capital is substantially eroded via draws on capital in order to maintain income levels. This chart includes some more recent experiences incorporating the GFC, but we have not allowed for potential income from aged pension entitlements. In each case, including the worst experience, initial equity investments would have sufficiently funded a retirement income for at least 25 years, and in many cases provided an additional capital legacy.

Chart 5: Capital remaining after living expenses

AIM Chart5 101014Source: Arnhem Investment Management. Past performance is not a reliable indicator of future performance.

Retirees might find this capital volatility too unsettling and are unlikely to take solace from the fact that holding all retirement funds in equities would have historically funded one’s retirement. Indeed, we have little doubt that those retiring in 1973 would not have had the resolve to maintain an equity portfolio, after seeing their retirement nest egg halve in just two years.

It should also be noted that this modelling assumes that spending power (in?ation) increases by 2.5% each year. Australia has however, experienced two periods of in?ation well in excess of this, in the early 1950s and the 1970s/early-1980s.

Would an equity portfolio have been able to maintain the real purchasing power while funding retirement through such extreme events? Based on historical equity market performance, the starting balance of $1,043,794 and starting income of $57,665 as used earlier can accommodate in?ation of up to 3.5% in all but one retirement year (1970). Lifting starting capital to $1,200,000 would see a retiree manage with in?ation of up to 5% in all years. However, they would have needed a far higher starting balance to maintain real purchasing power at the rates of in?ation experienced in the 1970s.


This analysis highlights the value of incorporating a significant equity weighting in an asset allocation during retirement years. We show that equities can deliver superior income outcomes and are a good hedge against in?ation. In addition, by choosing an equity portfolio which invests in companies that deliver growing dividends, financial circumstances may be better than if conservative ‘yield’ strategies are the sole focus. Returns from equities will be more volatile, and while they ought to form a meaningful part of post retirement income, they should also be balanced with lower volatility assets.


Mark Nathan is Managing Partner at Arnhem Investment Management.

This document is produced for general information only and does not constitute financial product advice, nor a recommendation to acquire any financial product. You should seek your own professional advice in relation to any financial product. The full research paper is linked here.


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Peter Vann

October 10, 2014

Hi Mark
First I believe that equities play an important role in investment strategies providing a good likelihood of safely funding higher retirement income streams. Strategies with significant allocations to low volatility assets such as bonds and cash are more risky with respect to funding the same retirement income levels.
I would also like to comment on the difficulty of modelling the dynamics of equity markets (and any other investment market) when drawing returns from historical data whilst capturing the impact of two “equally” important dynamics
(a) the volatility of the markets and
(b) the observation that valuations DO mean revert.
Some research papers model both (as does yours) and can only obtain a limited number of contiguous periods, say 30 year through retirement. To obtain more “simulations” quite a few researchers unlink the sequence of historical returns (eg by randomly drawing each return in their sequence of returns) but this ignores the important real world reversion of asset valuations. Hence when reading other papers, please be aware of this.
Also, one can also model returns distributions with valuation reversion “calibrated” from history; this method includes both of the above return dynamics plus allows better statistical analysis.


October 10, 2014

Hi Mark
I agree that there is a role for equities in providing long term returns and higher income in retirement.

I don't agree with your historical analysis. 1968/1969 were a couple of the worst years to be invested in equity markets because of the subsequent increase in inflation.
You correctly note that equities have adjusted over time to inflation to produce higher long term real returns, but then forget to apply it in your analysis of the historical data.

By assuming only 2.5% p.a. inflation you halve the real income during the 1970s. That is the retiree would on less than the modest standard by age 73 and it only gets worse and their capital would run out soon after.

Can I suggest you look at the work Michael Drew and Adam Walk did for FINSIA this year. They use the data set from 1900 with actual inflation and market returns. A 100% stock portfolio had a 99% chance of lasting 30 years only when the initial withdrawal rate was 3% (or lower).

Mark Nathan

October 13, 2014

Thanks for your comments. I will certainly look at the work of Michael Drew and Adam Walk.

You are correct about the inflation effect of late 60s and early seventies. This is acknowledged in the full version on the paper (http://www.arnhem.com.au/wp-content/uploads/2014/09/ARNHEM_The-Case-For-Equities-in-Retirement.pdf).
I am interested in thoughts about how one could best manage this sort of inflation should it recur? Certainly large holdings of cash is not ideal for the long term. There are not enough index linked bonds to go around. I also doubt that commercial annuity providers that offer a 100% inflation hedge would be able to asset match (or otherwise manage the risk) should large numbers of retirees take that option.

Warren Bird

October 14, 2014

Inflation linked bonds really are the only way to get a reliable hedge against unanticipated inflation. All other strategies rely on markets and central banks behaving in certain ways.

Nominal bonds do better than most people think. When inflation rises, bond yields rise. Everyone focuses on the short term hit to the capital value of a bond portfolio when that happens, but forgets that those hits eventually disappear (the bond matures at par, even if its price falls to, say, 95 in the meantime) and reinvestment returns therefore ratchet higher. (I'm talking about reinvestment of maturities as well as of interest.)

People also tend to do their analysis in terms of a ten year bond and argue that 'this is too long to be locked into low yields'. But the typical bond fund - at least in Australia - is only around 3.5 - 4.0 years duration. So within 3-5 years half the fund has matured and been reinvested at higher yields.

If at least some of the coupon interest has been reinvested to help maintain the real value of the investment (see my article here for more on this http://cuffelinks.com.au/bonds-role-managing-inflation-risks/ ) then bonds over a medium term timeframe can still deliver positive real returns even during rising inflation.

If you knew it was going to happen then you'd be in cash for at least a while and gradually dollar cost average into a bond portfolio at higher yields than at the start. But since we're talking about unanticipated inflation, you don't know it's going to happen. And if it doesn't happen, then you want the extra yield over cash that bonds give you in a positive yield curve environment.

So while Mark is right that there aren't enough inflation linked bonds to go around, there are plenty of nominal bonds and they can be made to work OK as part of an inflation hedge strategy.


October 14, 2014

Thanks for the link. It is an interesting read, although the numbers are still using high nominal equity returns in the high inflation period, but assuming only 2.5% inflation, thus assuming real returns of 8% pa v 3% in reality.
Using the 1965 numbers in the paper with actual inflation, the money runs out in 1986, far from a multi-million dollar estate balance in 1990.

To manage inflation, the best hedge is inflation-linked bonds. Long term investments are about compensation for risk and removing a large risk will reduce the expected return.
As you note, cash can also hedge inflation (reasonably well) but long term returns are poor. The same is true for direct commodity investments. Equities are a poor hedge against inflation shocks (prices tend to fall) but generally provide the highest expected long term returns (in real or nominal terms).
Inflation is just another risk that investors need to balance when they allocate between risky and "risk-free" assets. the real question is how much do you want to hedge: 100% is unlikely to be the right answer for most investors.

Let me finish by being clear that I agree with the thrust of your points: There is a clear role for equities in retirement. Most retirees also want some protection against inflation and other risks.


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