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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.

 

12 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.

Andrew Wilson
December 13, 2020

Agreed, there is a behavioural benefit.

From a mathematical perspective the two scenarios are similar but not the same. The asset class returns are assumed to be the same for consistency; however the level of draw down on each asset class is different in each scenario.

We haven’t applied retrospective market timing, rather we’ve applied rules to determine when changes are made:
1. Start with 2x years income in cash
2. Draw from shares annually to maintain 2x years income in cash
3. Use cash reserve to avoid selling shares after market crash
4. Ensure cash reserve is never less than 1x year income
5. Stay within +/- 10% of risk tolerance

The risk is the same in year 1. The investor does not deploy additional capital to increase risk or rebalance at lower points thereafter, though that could add value. Instead the changing % allocation to shares is a by-product of the compounding returns and the draw-down strategy.

As to whether or not the strategy is appropriate will depend on how the investor defines risk:
• As allocation to equities, then yes the risk does change through the cycle; or
• The likelihood of achieving their income goal - which is what the bespoke strategy aims to achieve.

As for when an investor would run out of cash in an extended down-turn, they would have 2-years cash reserve which will also be topped-up by income arriving from investments. As the cash reserve approaches $0, the fixed interest part of the portfolio could be sold-down, and we would hope bond prices have risen as a result of what would be an extended downturn. This gives the investor 5-7 years to ride out a down-turn before selling shares. In the diversified strategy the investor would be selling down their growth assets right through the down-turn.

Again, it’s not the only way but the strategy has given our clients comfort through market downturns.

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.

 

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