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

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.

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

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Whilst each generation has very different needs and priorities when it comes to managing their money and their finances, an increasing number of cases are arising where the decision of one generation is having a detrimental effect over the financial stability of other generations. Perhaps the most common example of this is adult children seeking large sums of financial assistance from their aging parents. This is due to a range of reasons, most of which could be avoided if they had were more prepared. 

Whilst pre-retirees and retirees are focusing on the growth and longevity of their nest egg, their children are more focused on education, buying their first homes and starting a family. We are often so focused on our own financial goals, that we don’t consider how our family’s decisions and experiences can have an effect on those around us.

If a child finds themselves in financial difficulty due to factors such as redundancy, illness or debt, most parents first instinct will no doubt be to help their children by providing financial support. This, however, can have a significant impact on the parents’ superannuation nest egg, value of their estate and their quality of life during retirement.

Take Sally and Mark, for example.

Sally and Mark had just retired, and were looking forward to their upcoming golden years, spending quality time with their children and grandchildren and travelling around Australia as they had always planned to do.

Unfortunately, only 6 months into their retirement they had a devastating call advising that their son, Michael, had suffered a heart attack and passed away.

Because he was a fit, healthy man in his late thirties, Michael had not seen the need for any life insurance and for this reason his wife, who was a stay at home mum, was now left to manage their two children and mortgage on her own.

As most parents or grandparents would do, Sally and Mark welcomed their daughter in law and grandchildren into their family home.

The financial impact on Sally and Mark’s retirement plans was enormous. In order to support their daughter in law and grandchildren meant that their retirement plans were no longer what they had originally intended, and Sally and Mark would now need to live a very modest lifestyle in order to make ends meet.

*This case study is for illustrative purposes only.  

It is important to encourage discussions with your children from an early age, and ensure they are educated around their finances in order to avoid these situations. Arming your family with as much information as possible will assist you in helping each other for the long term.

By planning together and communicating, all generations can enjoy a better financial future.

Have you considered how the following issues may impact members of your family? What are some of the solutions to consider to address these issues?

For 20 somethings:

29% of Gen Y are “financially unfit” – high debt, no insurance, few savings and expensive accommodation.¹

–          Struggling to manage credit card debt

–          Low income

–          Paying off HECS debt

–          Increasing rental costs

–          Relative lack of awareness regarding finances

–          Living costs (many holding a live now, pay later mentality)

Things to think about:

–          Consider avoiding a credit card

–          Budget wisely

–          Educate yourself about your finances

–          Start planning for your future now – start a savings plan now- linked high interest account “pay yourself”

–          Live according to your income

For 30 somethings:

Only 53% of 30year olds believe they could survive longer than a month if they were unable to work.

–          Job stability and salary packages hit by financial crisis

–          Increasing property costs

–          Mortgage stress

–          Young families to support

Things to think about:

–          Speak with your Financial Planner about Risk Cover

–          Consider debt consolidation

–          Ensure you don’t overextend yourself when purchasing a property

–          Budget wisely

–          Don’t forget to think about your super

–     Consider some salary protection, life trauma insurance

For Pre-Retirees & Retirees:

It costs around $350 per week to support an adult child. That’s money many pre-retirees and retirees desperately need to build – or rebuild – into their retirement next egg.²

Around 22,500 Australian grandparents are looking after their grandchildren.³

–          young adult children living at home

–          lending money to children for major life expenses – i.e.: first home.

–          supporting children who are not coping with financial debt

–          instability of markets and the GFC shrinking super accounts

Its not too late to discuss these issues with your financial planner to learn about how they can help your family better plan for its collective future.

Visit:

www.financialplanner-newcastle.com.au

www.selfmanagedsuperfundstrategies.com

www.leenanetempleton.com.au

www.newcastle-accountant.com.au

Source: Lonsdale Financial Group

¹  Bankwest, Social Indicator Series, as sourced by BT Financial Group

²  What price the clever country? The costs of tertiary education in Australia, AMP. NATESM income and Wealth Report, 21 November 2008 and Honey, I calculated the kids… it’s $537,000, AMP. NATSEM Income and Wealth Report Issue 18 December 2007 as sourced by BT Financial Group Limited.

³  ABS: Family Characteristics, Australia, 2003 as sourced by MLC Insurance

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