SMSF Technical Education & Strategies

 

Introduction to the 3 key areas of retirement income optimisation

This is the first introductory article in a series that looks at how to fully optimise your retirement income while managing the key risks.

Being financially secure with sufficient income in retirement is an obvious goal for most people. We work hard for most of our life, saving our earnings, and in some cases making significant sacrifices during those years in the hope that we’ll be able to relax and lead the “good life” in retirement.

But of course the “good life” costs money, and plenty of it. All of a sudden your not working, and that weekly paycheck is not there anymore to fund all those living expenses. Not to mention the big ticket items like a new car, or replacing household goods – and heaven forbid, an annual holiday !

 

Now, the ideal that we all strive for is to save enough capital while we are working, whereby a conservative recurring investment return on our capital will comfortably cover our annual budget of living expenses in retirement. And if we’re really lucky, a little bit extra to grow the capital base each year to cover inflation.

 

But what if we haven’t saved enough money ?

If we have not quite saved enough to meet this ideal, then luckily we do have a little safety net in the form of the Age Pension. Whilst it’s really not much money to live on if it’s your sole source of income, a ‘part pension’ is very valuable in topping up your earnings from your investment capital. In fact, it can be just the ticket to get you to the level of income you need in retirement to start to feel comfortable.

 

So in the end, many people do indeed end up living off a combination of:

 

1. Investment earnings from their capital (both super and non-super assets), and;
2. A part age pension

 

And for many people this does them just fine. You start your retirement with a certain amount of capital, providing you with a certain amount of income (either with or without a full or part age pension), you adjust your lifestyle and expenses accordingly, and off you ride into the sunset to start your new retired life.

 

So what’s the problem ?

Whilst the final paragraph above seems fairly straightforward, the harsh reality is that it seems far too many people have come unstuck in a dramatically negative way when it all seemed so simple when they started. And it can usually be traced to a problem in one (or more) of the three areas that we discuss below.

 

Optimising your retirement income

There are 3 major areas when it comes to Retirement Income that you need to address to ensure you are optimizing your outcome and minimising your risk of it all going pear shaped.

 

1. The initial “tax & pension” retirement strategy

The initial “tax and pension” retirement strategy centers on structuring and owning your assets in such a way where you are legally paying the least amount of tax, and getting the most age pension available, whilst maintaining access to sufficient capital if you need it.

 

With regard to tax, most SMSF members will look to establish an account based income stream (SMSF pension), as it is entirely tax free after age 60. For most people, this is relatively simple to achieve with sufficient pre planning to move assets into this tax free environment. Note also, that tax offsets such as the Low Income Tax Offset & Senior Australians Tax Offset can mean (subject to conditions) that couples can have tax free income of up $53,360 even if you don’t use a superannuation income stream, so remember its not always just about super. It depends on your individual circumstances.

 

With regard to the age pension, strategies are somewhat limited although there are situations such as moving assets into the super fund of a partner who is not yet age pension age, as super assets are not means tested for those under age pension age. Even one dollar of age pension can be very beneficial given the discounts that can be enjoyed from the pensioner concession card. There are also strategies such as increasing the deductible amount of a SMSF income stream, as it reduces the amount counted as income in the income test.

 

This is generally where a good financial adviser experienced in retirement planning comes into play. They can create for you a statement of advice based on your circumstances, outlining the proposed strategy and income projections, for a fixed dollar fee.

 

2. The ongoing “capital usage” strategy.

This is where things start to get very interesting.

 

The ongoing capital usage strategy deals with how you use up your capital over time. It is a fairly new concept with very few people (if any) doing any modeling around this.

 

Why is it important ? Because it addresses two very important issues:

 

(a) Longevity Risk

Longevity risk deals with the risk of you outliving your life expectancy and/or running out of money in retirement.

You see, the modeling done in step one above will normally use your life expectancy when looking at how long your assets will last, and how much income will be paid over time.

 

But here’s the thing – 50% of people will outlive their ‘official’ life expectancy, PLUS your life expectancy is NOT static. The longer you live, the more your life expectancy grows. For example, if you start retirement with a life expectancy of 20 more years, you don’t have a life expectancy of 0 if you survive to that point. Rather, the expected date of death gradually increases over time for those that survive. So the static plan is a poor one. Another approach is to use a buffer approach to age 100, but this is not optimal either. Rather, the optimal approach is to use what is called an annual “rebalancing method”, whereby you readjust the expected planning duration for survivors as time passes to take into account updated information to that point of time. The strength of this method is that it doesn’t try to forecast – rather, it sets up a procedure to manage the uncertainty. Proceeding articles in this series will look at this in more detail and show how it works.

 

(b) Optimising age pension over time

Your Age Pension entitlements in future years are influenced by the rate at which you draw down your retirement assets, due to the age pension means tests.

 

A fast drawdown rate may mean more age pension in future, but of course running out of money sooner. A slow drawdown rate may result in little or no Age Pension entitlement. You may also have an estate planning goal of leaving a certain amount of money to your family members in the event of your death. Plus, you have the situation where it is highly likely that one member of a couple will pass away prior to the other, and as such less income is required and the remaining member will be under the more limited single member means tests.

 

So what to do ?

 

Using actuarial techniques, a capital usage plan can be established to take into account a large range of variables, with the goal of optimizing your future age pension entitlements. Again, we’ll have more detail on this in the proceeding articles in this series.

 

3. Asset Allocation, tailored income portfolios, and real investment risk.

The wrong asset allocation can be disastrous for retirees. The constant drawing of income means that significant falls in growth markets (such as the share market) can mean a permanent shifting down of your capital base (and hence future income potential) if you have too much exposure to those asset classes.

 

This is probably the most common problem we’ve seen particularly over the past decade. In future articles, we are going to explore some different approaches to this topic, including using tailored bond portfolios to immunize the income of your portfolio, such that the ‘residual’ allocations to growth asset classes such as equities can be used in a more ‘stress free’ way.

The other key issue is individual investment risk, and understanding the idea of risk being that of “permanent capital loss” versus just price volatility, and being able to identify the difference.

 

Bringing it together

Optimising and tailoring each of the above area’s individually will, as an aggregate when all combined together, enable you to fully optimize your overall retirement income and ensure you don’t run out of money in retirement.

 

The next installments in this series will focus on No. 2 and No.3 above, as this is where we believe there is much to learn and where we think many improvements can be made.