Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 375

Funding retirement through a stock market crash

Most retirees have seen their savings fall in value over the past six months and may question whether this affects their ability to fund a comfortable lifestyle for the duration of their retirement. Seeing investment values fall is undoubtably an unpleasant experience; however, it doesn’t need to have a lasting impact on retirement plans.

Protect your future cash flow

In a best-case scenario, a retiree’s annual living costs are met by income from investments including those held inside superannuation. Living off investment income avoids eating into the capital value of retirement savings and funds a comfortable lifestyle in perpetuity.

However, dividends and distributions can be lumpy and at times, unpredictable. Building a cash reserve within a super fund can provide a safeguard to ride out investment market volatility and avoid selling investments at a low value. The cash reserve should typically be the equivalent of 1-2 years of living expenses. As an example, if living expenses are $90,000 a year, the cash reserve should fluctuate between $90,000 and $180,000.

Contrasting two common super strategies

In this article, we contrast two super fund structures and the impact of drawing a regular income from each during a market down-turn.

1. Single unitised investment such as a diversified fund

These are single investment options within a super fund that comprise a range of assets such as shares, bonds and cash. The member purchases units in the investment option along with other members of the same super fund. Each member receives a share of the investment return proportionate to the amount they invested.

These are the most common super fund structures and typically have names such as ‘Conservative’, ‘Balanced’ and ‘Growth’.

When a member draws retirement income from these structures, they are selling units in the investment at the current market value.

2. Portfolio + cash account

Let's call this a bespoke portfolio, such as an SMSF. Each member selects shares, bonds and managed funds in which to invest their superannuation. The super fund also has a cash account which receives any investment return and from which regular payments to the retiree’s personal bank account are made. Each member’s return is based on their own individual investments, irrespective of other members of the same fund.

These are typically SMSFs or super wraps. The key point is that the retirement income comes from drawing funds from the cash account rather than selling investments.

Case study

Consider a retiree with superannuation savings of $2,000,000 who requires $90,000 a year to fund a comfortable life. They have a balanced risk tolerance, allocating 65% of their savings to shares to generate a higher long-term return and 35% to interest-bearing investments for stability.

Let's assume the retiree's average return over a 10-year period is 6.6%, including a share market decline of -20% in year 5 and a recovery in year 6. For simplicity, outside years 5 and 6, we have assumed a constant return in each asset class year (shares: 10%, fixed interest: 3%, cash: 1%).

This table shows the total return we have assumed in each year:

Strategy comparison

Diversified Fund

  • Each year the member draws $90,000 from their balance to fund their living costs.

Bespoke Portfolio

  • The member starts with the same investment allocation as the Diversified Fund, including a cash reserve of two years of income (i.e. $180,000)
  • Each year they draw $90,000 from the cash reserve
  • Prior to the market crash, they top up the cash reserve annually back to $180,000 by drawing on their investments
  • Shares are not sold after the market crash which results in the cash reserve reducing temporarily
  • After share markets recover the cash reserve is topped up gradually ensuring it never falls below $90,000.

Possible outcome

The chart below compares the value of the Bespoke Portfolio relative to the Diversified Fund. Over a 10-year period, the Bespoke Portfolio gains an additional $80,812.

This difference is primarily a result of allowing investment returns to compound over longer periods, but this is also the cause of the negative outcome in year 5. The cash reserve allows the retiree to preserve their share market investments during the market correction helping their retirement savings grow in future years.

 

The main reason the Bespoke Portfolio does better is that shares are not sold after the market crash, as income needs are met from the cash reserve. In this example, the Portfolio then benefits materially from the 35% gain in the following year.

Other considerations

Other considerations that will impact the future value of the retiree’s savings:

  • Starting allocation to shares vs fixed interest investments
  • Frequency and level to which the cash account is topped up
  • Regularity of rebalancing between asset classes
  • Fees and costs of the super fund and financial advice
  • Taxation on investment returns.

Here we’ve compared only the super fund structures and assumed all else is equal. There are many other considerations including insurance options, estate planning and ease of management. There is no right or wrong, rather different fits for different situations.

Most important is that retirees have clarity on the cost of a comfortable life, understand where they want to be in the future financially and have a strategy in place to achieve these objectives. Don’t leave it to chance.

 

Andrew Wilson is a Client Director for Wealth Management at Pitcher Partners Sydney. This article is for general information and does not take into account your investment objectives, particular needs or financial situation.

 

11 Comments
Wayne
September 28, 2020

I understand the possible behavioral benefit of the bespoke scenario, but really from a mathematical perspective the two scenarios are the same. The only difference is that retrospective market timing has been applied for the bespoke scenario where the asset allocation was allowed to vary throughout the market cycle. With the unitised investment the asset allocation was held constant. Either approach could work out better depending on how the market returns were timed.

So basically, in the bespoke scenario the investor took on more risk during the downturn by increasing their weighting towards equities and reducing cash and in this particular example it happened to work out for them. In a different scenario e.g. a longer downturn it would give a poorer outcome because they would run out of cash.

Investor
September 22, 2020

Does this mean the best option for most retail investors is:
1 - Save up a cash buffer of 1 - 2 years living expenses,
2 - Don't sell in a panic after the market crash,
3 - Live off the cash buffer until the market returns to a 'normal' range,
4 - If you want to, sell some shares once they are back to a price where you aren't selling for a loss,
5 - Rinse and repeat through the next market crash.

SMSF Trustee
September 24, 2020

That's not far off what I do, "Investor"

Andrew Wilson
September 27, 2020

Yes, it's certainly a good option that has worked well for our clients over many years.

Andrew Wilson
September 27, 2020

Also, income from the investments will continue to flow in each year, topping up the cash reserve automatically. Depending on the amount you draw annually, and the level of income from your investments, this may reduce the need to sell assets to top-up the cash holding.

Some, but not all, companies have reduced dividends in recent months to help strengthen the companies balance sheet. A short-term dividend cut is likely to be a better alternative than a capital raising that permanently dilutes your holding and future income.

Michael2
September 20, 2020

My concern in having a cash reserve in Superannuation is if the fund refuses to release the money, as happened to some people during the GFC, with certain funds ( don't believe any were superannuation funds) refusing to release money or dramatically reducing payments eg from $1.18 down to $0.01 per unit.

That being said, I do intend having a cash 'bucket' within my superannuation to prevent me sellling down growth investments during the bad times.

Andrew Wilson
September 27, 2020

I'm not sure I understand Michael, are you perhaps referring to managed funds that froze redemptions during the GFC? i.e. mortgage and property funds.
If so the 'refusal to release money' is due to lack of liquidity of the underlying investments. In simple terms, the investor is unable to withdraw capital because the fund:
1. Has no cash to pay the withdrawal; and
2. Is unable to find a buyer at a reasonable price.
For this reason, holding quality assets that match your liquidity requirements is crucial. The cash reserve should assist with getting through these periods.

Andrew Wilson
September 17, 2020

Yes Richard, cash forms part of the interest bearing investments and both scenarios have the same starting equities allocation.
We experienced similar levels of comfort from our retiree clients knowing they had the cash reserve in place, meaning their lifestyle wouldn’t be impacted as a result of the market decline. This mitigated the need to sell units or hit the panic button.
Good point regarding the short-term guaranteed annuity – another option worth considering for retirees.
The bespoke strategy can be appropriate and produces good results for some. For others, the simplicity of the diversified fund is a better fit.

J.D.
September 16, 2020

So the diversified fund has 1.3m equities 0.7m fixed income And the bespoke one has 0.65 * (1820) = 1.183m equities 0.35 * (1820) = 0.637m fixed income 180k cash How exactly do you come to the conclusion that the bespoke one grows faster in those first 4 years?

Richard Brannelly
September 17, 2020

JD I'll think you'll find the $180,000 starting cash is a component part of the 35% allocation to interest bearing investments and not in addition too - so both portfolios start with the same equities allocation.
A point of note that Andrew didn't go into but that we would both experience in advising retirees - is that emotionally bespoke portfolio retirees respond better during the inevitable downturn in equities knowing they have the guaranteed cash reserve and can likely afford to await the also inevitable recovery. Some retirees facing a 15% or more fall in diversified unit prices and faced with selling units every month to meet pension income needs - hit the panic button and switch to Cash missing some or all of the recovery completely.
It is also possible for SMSF and Wrap retirees to replace the Cash account with a short term guaranteed nil RCV annuity matched to their expected drawings - a modestly higher interest rate than most Cash accounts but still provides the short-term guarantee of income. Dividends and distributions can then be used to rebalance the portfolio on a regular basis. Not for everyone as Andrew points out but well worth considering.

J.D.
September 17, 2020

It doesn't add up that way either.

In the first year for example, the same equity return on each side would be the same, but the bespoke one has some of their fixed income in cash, which would still result in lower returns, not higher.

Going by the numbers given in the example, having cash is a drag on returns, which is fine provided the investor understands that and accepts it, however from what I can tell the numbers tell the opposite story.

 

Leave a Comment:

     

RELATED ARTICLES

The case for equities in retirement

Why 2020 has been the year of the bond market

Poor start to 2016 is not a bad omen for Australian shares

banner

Most viewed in recent weeks

My lessons from five decades of investing

As she retires after 47 years as a portfolio manager, Claudia Huntington explains the art rather than the science of investing, the value of a great leader and culture, and the insights she gives to new colleagues.

20k now or 50k later? What’s driving decisions to withdraw super?

The amount of retirement savings withdrawn under the Superannuation Early Release Scheme has surprised many. This comprehensive survey of thousands of Cbus members explains their motivations.

Have the rules of retirement investing changed?

In retirement, we still want to reduce stock volatility while generating cash flows. The two needs have not changed, but the reward expected in the old days from interest payments has gone. What should we do?

One last hurrah for the 60/40 portfolio?

The 60/40 diversified portfolio has been the mainstay of the superannuation industry for decades. But it is built on a fundamental principle of defensive bond returns, and its time is nigh.

YourSuper will save $17.9 billion! Surely you’re joshing

In Budget 2020, Josh Frydenberg announced a performance comparison tool and fund stapling to save Australians $17.9 billion over 10 years. But too many moving parts make results highly cyclical.

The elusive 12%: is superannuation at a turning point?

Such is the concern among unions and Labor about Government plans to undermine superannuation that an 'Emergency Summit' was called this week, and pioneer Bill Kelty evoked a social commitment.

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 379

It is trite and obvious to say the future is uncertain, and while COVID-19 brings extra risks, markets are always unpredictable. However, investing conditions are now more difficult than ever, mainly because the defensive options for portfolios produce little income. We explore whether investing rules have changed with new input from Howard Marks.

  • 15 October 2020
  • 6
Retirement

Have the rules of retirement investing changed?

In retirement, we still want to reduce stock volatility while generating cash flows. The two needs have not changed, but the reward expected in the old days from interest payments has gone. What should we do?

Shares

Tech continues to run on rising prices not profits

The global tech run paused in September but the boom is driven by rising prices rather than actual profits. It will end when global confidence in the prospect of endless monetary and fiscal stimulus runs out.

Investment strategies

When defensive assets become indefensible, turn to tech

During COVID-19 and the economic recession, we are seeing a surprising new entrant to the defensive sector grouping. Technology shares have been behaving a lot like defensive shares such as food and utilities.

Interest rates

10 reasons low interest rates may limit growth

Ultra low interest rates could be counterproductive for economic growth. Policymakers need to rely less on monetary stimulus and be mindful of the side effects they are creating, especially for retirees and savers.

Financial planning

What the RC, Budget and Keating mean for aged care

Although the Aged Care Royal Commission (with Paul Keating) and Budget announcements gave the aged care sector high profile, the welcome 'granny flat' changes came with inadequate extra Home Care Packages.

Investment strategies

Is currency exposure an unwanted risk or source of returns?

As more Australians invest overseas, currency exposure represents a new risk. 50% hedged, 50% unhedged was once a popular ‘least regret’ approach, but there's a move to currency as a return source.

Shares

High growth and low rates incompatible with current share prices

The unrealistic value creation through lowering discount rates while assuming high growth shows a sensible link is critical. Interest rate assumptions need as much valuation focus as the cash flows of the business.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.