Oct 11

Living Longer – Making Your Retirement Savings Last

Will Your Retirement Savings Last?

It’s no secret we are all living longer: female baby boomers have a 50% chance of living beyond age 90, and males a 34% chance. But before you start planning how many more overseas trips or rounds of golf you can squeeze into these extra post retirement years, there
is the small matter of how to pay for it with your retirement savings.

It is a serious issue to know about longevity risk; longer living means taking extra measures to ensure an appropriate income to maintain your desired lifestyle for those 25-odd post retirement years. The key to managing longevity risk is to boost earnings, manage drawdowns, accelerate returns and time taxation accurately (see Figure 1).

However many Australians are not conscious enough of longevity risk and ways to mitigate this risk. For example, in the aftermath of the global financial crisis many people flooded money too heavily into term deposits which they perceived as safer.

In fact, term deposits increase longevity risk because the average term deposit interest of around 6%, as well as no capital growth, is not going to be enough to provide a decent income in retirement without having to sell assets.

Tax considerations are always important for investors but in retirement the benefits can be even greater. The money you save by being smart about tax can help combat longevity risk.

A tax deferred income fund, for example a direct property fund, normally pays distributions to investors. The tax on this income is deferred until the property trust investment is sold, at which point an investor pays tax at their marginal tax rate. The advantage for an investor in or near retirement is this rate could be much lower than their working tax rate. Also capital gains tax rules mean only 50% of the gain is taxable if an investment is held for more than 12 months – this is also relevant to tax deferred income funds.

According to a report Charter Hall recently commissioned with Strategy Steps, a leading provider of technical and investment services, investors need to construct their portfolios carefully to avoid falling into such traps. An example of how a portfolio might be structured using these principles is in Figure 2.

How to longevity-proof your savings: the investment risk/return conundrum

We have established that boosting income and not allocating too much to overly defensive assets like term deposits is important, so the question now is which investments are appropriate for those in or nearing retirement?

It can be difficult to identify income producing investments without taking on too much investment risk near retirement as any major losses can leave an investor with a big hole in their savings and little or no time to recover.

Figure 1 – The four keys to managing longevity risk

 Retirement Savings

 

Income Tax rate Tax deferred amount Taxable amount Tax payable Year 1 $1600 15% $1,120 $480 $72 Year 2 $1600 15% $1,120 $480 $72 Redeem investment 0% $2,400 $0


Figure 2 – Structuring the pension portfolio


Strategy 1: Draw pension from a cash bucket

Aim: Protect against market volatility in the early years by ensuring growth assets do not need to be sold to make pension payments

• Separate the portfolio into cash and growth portfolios and draw the income only from the income portfolio

• Income portfolio will hold secure investments e.g. cash. Place 2-3 years of income in the income bucket/portfolio
• Remainder of the portfolio is in growth based diversified portfolios

 

Strategy 2: Draw pension from balanced/growth portfolio

Aim: Select a portfolio to balance the growth potential and maintain diversification

• The portfolio is constructed based on a strategic asset allocation that fits with the client’s risk profile. This often relies on the use of model portfolios for a balanced or growth risk profile

• Income drawn proportionally from all assets to maintain asset allocation

 


Combating longevity risk by minimising tax

Tax considerations are always important for investors but in retirement the benefits can be even greater. The money you save by being smart about tax can help combat longevity risk.

A tax deferred income fund, for example a direct property fund, normally pays distributions to investors. The tax on this income is deferred until the property trust investment is sold, at which point an investor pays tax at their marginal tax rate. The advantage for an investor in or near retirement is this rate could be much lower than their working tax rate. Also capital gains tax rules mean only 50% of the gain is taxable if an investment is held for more than 12 months – this is also relevant to tax deferred income funds.

Case study:

Adrian is two years away from retirement and invests $20,000 in a direct property trust via his self managed superannuation fund (SMSF). The investment pays an income distribution of 8%, of which 70% is tax deferred. The tax rate of Adrian’s super fund is 15%.

Adrian’s super fund will receive an income return from the property trust of $1,600 p.a. of which $1,120 is tax deferred and $480 is taxable in each financial year. This equates to Adrian paying $72 in tax each financial year as the tax on the remaining income amount is deferred until the investment is sold.

At retirement, Adrian transfers the investment from his super fund to allocated pension funds. This does not trigger an income or capital gains tax (CGT) event.

Adrian decides to redeem the direct property investment after he retires. The deferred income amounts are included in the CGT calculation. Any CGT is taxed at the pension funds marginal tax rate, which is zero. Effectively Adrian pays no tax on any capital gain made on the trust and the deferred tax income amounts are tax free.

Newcastle Financial Tax

Thanks to the tax deferred component and zero capital gain tax payable, Adrian’s SMSF is $336 better off (i.e. tax payable – tax paid x 2 years, or $480 – $72 x 2 years).


Figure 3 – Comparison of strategies
 

The good news is there are some retirement savings solutions for those wanting high income and capital growth without the risk of volatility and investment losses that may come with higher growth assets.

For instance, direct property funds provide high, tax effective income and capital growth. Direct property is less dependent on the investment cycle, less volatile and has low correlation to the share market. See Figure 3 for a graph comparing the returns on various portfolios including direct property, which shows those that include direct property can perform better.

As outlined in Figure 3, over a ten year period, including the global financial crisis, Strategy 1 with the provision of up to 3 years cash for pension payments, provides greater preservation of capital and a higher portfolio balance. Where direct property is included in both Strategy 1 and Strategy 2, better investment results are produced.

With this in mind, investors should be aware of longevity risk and work with their adviser to help manage this risk. Speak with your financial planner about how to increase the longevity of your retriement savings.

Source: Richard Stacker, CEO Charter Hall, Direct Property


Disclaimer

 

For further information about your retirement savings please speak with your Newcastle Financial advisors also see the Self Managed Super Funds website.

 

 

 

click the following link for further retirement planning examples

Retirement Savings

About The Author