Growth assets essential for retirement health

As people live longer, how do retirees preserve their capital while also ensuring their pension funds grow enough to fund their income over the long term?

Retirees face the challenge of not knowing how long they will live which makes it difficult to know if you have saved enough capital to live on through retirement.

Increasing the horizon

Anyone living to the age of 80 and retiring at 60 will need an income that can cover their living and medical costs for 20 years. But a healthy, fit 60-year old could easily live to 90 needing capital to last for 30 years.

The amount of capital retirees have built up over the years determines how much income they can draw. If they want to avoid depleting their capital too quickly, they need to be conservative in terms of income during the early years. Drawing between 2.5% and 5% of their capital as a yearly income is an appropriate conservative approach for most retirees.

Early conservatism

The first five to eight years of retirement are the most critical in ensuring that clients don’t draw too much income. If retirees deplete their saved capital by drawing between 10% and 15% early on, it is impossible to make that back.

Ideally, they want to earn an investment return of between 6% and 9% per annum, while drawing an income of around 2.5% per year.

Retirees should ensure their capital is working as hard as possible. Many retirees make the mistake of believing they should have most of their capital in cash when they retire to avoid losing it through market volatility. While it is important to get the balance between growth and preservation right, it is vital that their capital is not losing ground to inflation.

The inflation factor

So if inflation is increasing at 6% year-on-year, and investment returns are 5% per annum, their capital is not keeping pace with inflation. This means they are losing purchasing power.

Retirees should consider dividing their total capital into three buckets: one-third conservative assets, one-third low-risk growth assets, and one-third more aggressive high equity-type asset allocation.

The first bucket is the income-providing capital for the first five to seven years of retirement. It should be a stable and conservative portfolio, without too much risk as it must provide an income. Typically you would invest it into fixed interest or a conservative portfolio.

The next portion of capital can be structured into a medium-term bucket which aims for an element of growth but with a reasonable amount of stability in terms of capital fluctuations. A low-risk growth investment, such as a balanced fund or similar portfolio is typically an option to consider. This bucket is aimed at providing income for about 12 years.

The remaining capital can be structured into more aggressive assets that provide higher growth for the long term.

The balancing act

Every two to three years, the portfolio will need to be re-examined and rebalanced according to changing economic conditions, income and growth needs.

A reasonable level of growth to achieve in the medium to long term, while still drawing an income, is in the region of CPI plus 2% to 3%. This equates to around 8% or 9% growth a year on the portfolio in today’s inflation environment.

Dividing that return across the three buckets equates to a return of around CPI plus 5% on the high growth equity-type assets (the long-term bucket), CPI plus 3% on the medium-term bucket (low-risk growth assets), and a return in line with interest rates on the short-term income bucket.

The idea is that later in retirement, your client’s income will grow to between 5% and 8% of their capital as time goes on. It is also key to have growth assets in the portfolio so the annual draw down (before changing the percentage drawdown) will keep up with inflation.