Episode Details

When working out a retirement strategy, often people try to work out the value of investments they will need by multiplying the amount of annual retirement income they will need by a nominal interest rate. For example, if you want $100,000 p.a. in retirement and you think you can earn an income rate of say 3% p.a., you’ll need $3.4 million of net investment assets. The more aggressive you are with your interest rate assumption, the fewer assets you need to meet your goal. The reverse is also true.

Beware, there are a couple of pitfalls with this approach.

It results in a lazy asset allocation

If all of your investment assets are invested in cash or fixed interest investments (such as government and corporate bonds) in order to generate a stable income, you have little protection from inflation. This is because these investments do not provide any capital growth. All their return is provided in the form of income and your capital stays the same – think term deposit.

This means that over time, your assets will be worth less and less in real terms – because of inflation, your purchasing power is reduced. For example, $1 million today will be equivalent to $477,000 in 30 years’ time assuming the inflation rate averages 2.5% p.a. over that period.

People are living longer. Medical technology is improving at an increasing rate. Therefore, we must consider the likelihood of living to age 100 and beyond. To ensure you don’t run out of money, you must ensure you invest in assets that provide some capital growth so that your money at least keeps up with inflation and hopefully increases over time.

You must account for taxes

Of course, you must account for any taxation liabilities. If all your money is inside super (and your balance is less than $1.6 million), then no tax will apply if you draw a pension. However, if you have assets outside of super, you will need to account for any income tax consequences. The good news however is that an individual can earn approximately $20,500 per year before they need to pay any tax. Therefore, hopefully you can share any personal income between you and your spouse to minimise any taxation liabilities. My point here is you must think carefully about ownership structures i.e. where your investments are held. Super is excellent, but you don’t want to put all your eggs in one basket. Putting all investment assets in one person’s name also typically isn’t very wise in the long run.

Markets will go up and down

The role of asset allocation (i.e. the methodology used to spread your money across various asset classes) is to smooth returns and minimises losses. That is, some asset classes are negatively correlated which means when one asset class generates high returns, the other will likely generate low or negative returns. However, if you invest in both asset classes in the right proportions, you will achieve better investment outcomes at a portfolio level. This (i.e. asset allocation) is the most important decision a professional advisor can help you with. Its an investor’s most important decision. Because investors cannot control markets or returns. But they can control where and how they invest their monies.

Therefore, by putting all your money in cash and fixed income assets, you risk missing out on a lot of returns. Take the last decade for example. Government bond returns have been historically very low – sub 3% p.a. Whereas international equity markets have provided a total return of just under 10% p.a. over this period of time. This demonstrates the perils of putting all your money in one asset class.

Sometime in the future, this will probably reverse. Equity markets will perform poorly, and bonds will perform