Our analysis shows that the scariest thing about investing in retirement is not the risk associated with equities but the possibility of outliving our funds, or longevity risk. On one hand, equities may very occasionally have bad runs of six years or more, which would put a significant strain on retirees’ funds. On the other hand, however, is the very real possibility of living for 30 or 40 years after retirement. Thus retirement investing strategies have to walk the thin line of conservatism to avoid financial collapse through over-aggressive invest- ments while providing for increasingly longer lifespans.
To give an idea of what the experience of investing in retirement might be like for representative types of retirees, we have conducted a number of simu- lation experiments. We simulated the experience of investing and spending in retirement under four scenarios. These scenarios were formulated with assis- tance from a number of advisers who are well versed in the experiences of advising retirees. Although stylized, they give an indication of the impact of equity investments in retirement.
Our simulations of the retiree experience are based on a number of assump- tions. We assume that the retiring age is 60. We do not assume a particular life expectancy. Instead we allow for the possibility of a very long lifespan of 100 years or more, which may not be unreasonable. We have assumed four levels of income/wealth for retirees.
We have divided the total number of years in retirement into three phases, according to our perceptions of likely expenditure patterns. The first ten years of retirement are characterized by the highest annual expenditure, as this is the period in which retirees will be most likely to undertake travel and other extra-
curricular activities. In the second ten years, expenditure is lower per annum than in the first ten. In the last phase of retirement, we assume that the largest portion of income is necessary for health care expenses. Excluding health care, we assume that retirees have few additional expenses. Therefore, the third phase of retirement has the lowest per annum expenditure. We assume that the investment asset allocation remains constant over each phase. The details of the assumptions used are given in Table 2.1.
For simplicity we assume that each retiree has the choice of investing in a combination of two investment assets: a riskless asset such as cash and an equity asset that is risky. We assume an average annual real return of 10 per cent and a standard deviation of 14 per cent for the equity asset. These corre- spond with the 20-year historical average return and standard deviation figures for Australian equities. Drawing values from a normal distribution with these mean and standard deviation parameters simulates the return on equities in each year.
The riskless asset is assumed to have a known real return of 3 per cent. If each investor only invested in the riskless asset, he or she would run out of funds at the age of 66 under Scenario I, 72 under Scenario II, 84 under Scenario III and would not run out of money over a reasonable lifespan under Scenario IV.
Our task is to evaluate the benefit of investing in equities over the different phases of retirement. The criteria for a favourable investment strategy are that the retiree does not outlive available funds and can maintain a desired lifestyle.
As a measure of the gain of including equities in retirement investing, we measured longevity risk or the possibility of outliving retirement funds, given a certain asset allocation between the risky and riskless assets. If a retiree runs out of his/her own funds, he/she would have to rely on social security payments or sell other assets not considered in this portfolio. We calculated the probability of running out of funds at each year after retirement, given a certain asset allocation.
The expenditure for each year is accounted for at the end of a particular year, after which the remaining investment funds after drawdown are carried forward to the next year. The remaining funds then earn a particular invest- ment return for that year, which is accumulated to the fund at the end of the year. All figures are in real (inflation-adjusted) terms.
We simulated a number of alternative asset allocations for Scenarios I to IV.
We have assumed that the proportion of equities in each phase remains constant, but is allowed to vary across the hypothesized phases of retirement.
We do not account for any fees or taxation issues.
To simplify the scenarios, given the myriad of possible combinations of the two assets, we have assumed that the proportions of equities held in each phase of retirement are 80 per cent, 40 per cent and 0 per cent, with the Investing in equities for retirement 35
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SCENARIO I: SCENARIO II: SCENARIO III: SCENARIO IV:
Low income Middle income High income High net wealth
Lump sum at beginning $100 000.00 $250 000.00 $500 000.00 $1 000 000.00
of retirement Phase 1: 60yrs–70yrs
Duration (yrs) 10 10 10 10
Annual expenditure –$20 000.00 –$25 000.00 –$35 000.00 –$50 000.00
Phase 2: 70yrs–80yrs
Duration (yrs) 10 10 10 10
Annual expenditure –$15 000.00 –$20 000.00 –$25 000.00 –$35 000.00
Phase 3: 80yrs onwards
Duration (yrs) 10 10 10 10
Annual expenditure –$10 000.00 –$15 000.00 –$15 000.00 –$30 000.00
remaining proportion invested in the riskless asset. We have deliberately chosen three extreme positions of equity allocation of 0 per cent, 40 per cent and 80 per cent in order to highlight the resultant differences in outcome.
A buffer minimum allocation of 20 per cent to the riskless asset has been allowed, to provide some amount of guaranteed financial security to retirees.
This minimum riskless allocation provides some allowance for drawdowns to be made in periods of negative market performance without having to liqui- date equity assets.
A 0 per cent allocation to equities in any phase of retirement is the most conservative and a 40 per cent allocation to equities is considered moderate.
We assume that retirees are more likely to wish to be more conservative in the latter years of retirement than in the former. Thus we have eliminated those combinations where the proportion of equities in the latter phases is higher than in the former phases.
The scenarios and allocations reported in this chapter are not in any way to be regarded as advice as they do not take into account the particulars of actual individuals. Rather than recommending actual allocations to equities, our simulations are intended to provide indicative results as a point of comparison between alternative investment strategies.
Figure 2.9 shows the cumulative probability of a low-income individual reaching zero wealth in the years following retirement, for the various propor- tions of equity investments in the three phases. Each line in the graph repre- sents a different combination of the proportions of equity investments in the three phases. For example, ‘80: 40: 0’ indicates that there is an allocation of 80 per cent equities/20 per cent riskless assets in the first phase, 40 per cent equities/60 per cent riskless assets in the second and 0 per cent equities/100 per cent riskless assets in the last phase.
Regardless of the allocation to equities, the results for low-income individ- uals are bleak. For an individual who has a comparatively low lump-sum amount at the beginning of retirement, yet wishes to maintain some standard of living, our simulations show zero wealth at 60 to 70 years, regardless of the asset allocation.
This result occurs because of the low investment fund pool combined with rapid drawdowns in the early part of retirement. An investment in equities must be held for a reasonable period that is sufficient to accumulate gains.
Because of the rapid drawdown of funds in the first few years of retirement, the pool of funds invested deteriorates at too rapid a pace to allow income to be maintained into the second and third phases. Unfortunately retirees with only a small lump sum available at the start of retirement will probably have to rely on social security payments and/or be willing to accept a lower than desired lifestyle.
The outlook for a middle-income retiree with a $250 000 lump sum available Investing in equities for retirement 37
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0.8:0.8:0.8 0.8:0.8:0.4 0.8:0.8:0.0 0.8:0.4:0.4 0.8:0.4:0.0 0.8:0.0:0.0 0.4:0.4:0.4 0.4:0.4:0.0 0.4:0.0:0.0 0.0:0.0:0.0
Age at zero wealth 60
Cumulative probability (%)
90 80 70 60 50 40 30 20 10 0
62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98100102 104106108110
Figure 2.9 The cumulative probability of zero wealth in retirement – low-income retirees
at retirement, shown in Figure 2.10, is more promising. In this situation, our simulations show that in the first decade of retirement, retirees can maintain their desired lifestyle with little risk of running out of money, regardless of which investment strategy they adopt.
However, the asset allocation of the first phase becomes crucial in the second phase. The probabilities of running out of funds while maintaining a certain level of expenditure increase at a very rapid pace in the second phase.
For retirees with no allocation to equities in any phase, our experiment indi- cates zero wealth with certainty from the age of 72.
For a retiree with a 40 per cent allocation to equities in the first phase, but no allocation in the next two phases, the probability of zero wealth increases rapidly. The next most detrimental strategy is to have a 40 per cent allocation to equities in the first two phases, but no allocation to equities in the last phase.
The probability of zero wealth is considerable, yet decreases significantly for an individual who takes an aggressive stance on equities in the first phase of retirement but no equities in the latter two phases.
For strategies with a significant allocation to equities, the incremental prob- ability of running out of funds is very low from age 85 onwards. The proba- bility of equities sustaining a bad run over an investment period of more than 15 years is minimal.
Comparing the performance of the alternative investment strategies in Figure 2.10, a clear pattern emerges. The simulations advocate an aggressive allocation to equities in all phases of retirement for middle-income retirees, to minimize the probability of running out of funds. For middle-income retirees, the probability of economic death in any phase of retirement is lowest when the majority of funds are invested in equities over the whole retirement period.
As the allocation to equities in each phase increases, the probability of running out of funds at each age decreases.
The probability of running out of money at any age declines as the propor- tion of equities increases because even with the longest estimated bad run of six years, equities provide the potential for gains in the long run that far outweigh their riskiness.
For high-income individuals, shown in Figure 2.11, who choose to invest in risk-free assets only with no exposure to equities, the risk of running out of funds increases dramatically. By the age of 85, the drawdowns on their funds are far greater than the low interest accumulated by investing in a risk-free cash asset. The probability of zero wealth in the first 15 years of retirement is insignificant, regardless of the investment strategy.
Even for a lifespan of 90 years, the probability of economic loss does not exceed 15 per cent for any strategy, excluding that which does not contain any equity investments. However, allowing for the possibility of a long lifes- pan of 100 years, individuals are least likely to run out of funds if they invest Investing in equities for retirement 39
40
Figure 2.10 The cumulative probability of zero wealth in retirement – middle-income retirees Age at zero wealth
60
Cumulative probability (%)
90 80 70 60 50 40 30 20 10 0
64 66 70 72 76 78 82 84 88 90 94 96 100 102 106 108
0.8:0.8:0.8 0.8:0.8:0.4 0.8:0.8:0.0 0.8:0.4:0.4 0.8:0.4:0.0 0.8:0.0:0.0 0.4:0.4:0.4 0.4:0.4:0.0 0.4:0.0:0.0 0.0:0.0:0.0
62 68 74 80 86 92 98 104 110
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Age at zero wealth 60
Cumulative probability (%)
100 90 80 70 60 50 40 30 20 10 0
64 66 70 72 76 78 82 84 88 90 94 96 100 102 106 108
0.8:0.8:0.8 0.8:0.8:0.4 0.8:0.8:0.0 0.8:0.4:0.4 0.8:0.4:0.0 0.8:0.0:0.0 0.4:0.4:0.4 0.4:0.4:0.0 0.4:0.0:0.0 0.0:0.0:0.0
62 68 74 80 86 93 98 104 110
Figure 2.11 The cumulative probability of zero wealth in retirement – high-income retirees
42
Age at zero wealth 60
Cumulative probability (%)
90 80 70 60 50 40 30 20 10 0
64 66 70 72 76 78 82 84 88 90 94 96 100 102 106 108
0.8:0.8:0.8 0.8:0.8:0.4 0.8:0.8:0.0 0.8:0.4:0.4 0.8:0.4:0.0 0.8:0.0:0.0 0.4:0.4:0.4 0.4:0.4:0.0 0.4:0.0:0.0 0.0:0.0:0.0
62 68 74 80 86 92 98 104 110
Figure 2.12 The cumulative probability of zero wealth in retirement – high-net-wealth retirees
a significant portion of their funds in equities. Retirees are most likely to face financial difficulties when they do not undertake any equity investments in the latter phases of their retirement.
For retirees classified as ‘high net wealth’ retiring with a considerable lump sum of $1 000 000 or more, our simulations shown in Figure 2.12 indicate that the chance of running out of funds at any time in their retirement is extremely low. Where such a large sum is invested, despite frequent drawdowns, the capital invested is sufficient to earn the income necessary to maintain the chosen lifestyle. The long investment period coupled with the large fund over- comes any losses in the equity portion of the investment.
The lessons from our simulation analysis are very much in favour of includ- ing equities as part of a sensible investment strategy, over an individual’s entire retirement period. Regardless of the size of the lump sum available, retirees are estimated to be least likely to outlive their funds if a significant portion of their funds are invested in equities. The potential long-term profits from equities outweigh their risks, including the risk of a prolonged bad run.
However, the assumptions made on the lump-sum amount invested at the start of retirement and the annual drawdowns are crucial to this result. If these values are such that the drawdowns erode the investment capital at a pace that is too rapid, the investment capital will not have sufficient opportunity to accu- mulate gains. Given a healthy lump-sum payment and a sensible lifestyle, the probability of encountering financial difficulties during a lifespan is low.