Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 70

Diversification’s focus moves to matching future needs

This series on investment diversification has focussed on the mathematically precise world of expected returns, risk and correlations. But modern portfolio theory assumes a world without fees and taxes where all investors have the same time horizon and access to the same information. It also assumes investors are able to interpret and act on details in the same way and have identical unbiased expectations regarding the future. In the real world of investing, these assumptions are too simplistic.

Consider investment forecasting. Correlations, rather than being static, change over time, and risk (however defined) is no more stable. Volatility is itself volatile, as the below chart illustrates:


Data supplied by S&P Dow Jones Indices

The previous article used the terms risk and volatility interchangeably. Why? Because modern portfolio theory holds that volatility of returns is the most appropriate measure of risk. But is this the way people actually view risk?

In over a decade of advising individual clients, nobody asked me about their portfolio’s standard deviation, or how it sat relative to some theoretical efficient frontier. Clients had a keener interest in the change in portfolio value between review meetings, and paid far more attention when these were significantly negative than equivalently positive. In behavioural finance, this asymmetric concern is known as loss aversion. Therefore, let’s put to one side the neat world of modern portfolio theory and consider instead how diversification can be applied to real-world retirement planning.

Framing retirement objectives appropriately

Why bother saving for retirement at all? We do so to smooth our lifetime consumption. If we did not (with charity and social security offering inadequate safeguards), we would swing from exuberant spending in our working years to relative poverty in retirement. Modern portfolio theory forces a single-period risk/return frame onto individuals, when focus might be better directed toward a multi-period consumption frame. A schism exists in the understanding of risk between superannuation trustees and members. Trustees view risk via a text book definition of volatility (standard deviation). Members see risk as a failure to generate sufficient purchasing power in retirement to allow for a preferred level of consumption through it. Whose view of risk is more relevant? Whose risk is being managed?

Funding retirement consumption

It is possible to estimate the value today of the future cost of retirement. It is the present value sum of each year’s expected cost of living for the number of expected retirement years.

Consider an example of a recently retired 65-year-old male. Using the current Association of Superannuation Funds of Australia (ASFA) retirement standards for a single person ($23,283 p.a. for a modest lifestyle and $42,254 p.a. for a comfortable lifestyle), the total retirement cost today sums to $336,000 for the modest lifestyle and $610,000 for its comfortable equivalent. A 65-year-old female would require $374,000 and $679,000 respectively, due to higher life expectancy.

Whilst these numbers are sensitive to inflation and discount rate assumptions, and subject to some variability due to heterogeneous later-life health care costs and longevity risk, they provide a valuable insight into retirement expenditure on average.

Armed with a measure of retirement cost, we now have a basis for comparing these prospective liabilities against retirement assets. To do so we need, however, to consider the totality of assets capable of funding retirement.

It is unlikely that the average retiring 65-year-old male will have $610,000 in superannuation. APRA data currently suggests $151,000 as a more likely balance. Such a large superannuation balance may not, however, be necessary for two reasons:

1. The government age pension
The age pension is effectively a government-backed lifetime indexed annuity. One recent study estimated the value to life expectancy of the full age pension is $377,000 for a 65-year-old male. As some 80% of retirees will receive at least part age pension, it will continue to remain an important ‘shadow retirement asset’ (despite the changes foreshadowed in the government’s 2014/15 Budget).

2. Other non-superannuation assets
Non-super assets such as shares and property play an important role in real-world retirement funding. A recently released Melbourne Institute/Towers Watson working paper calculated median wealth (excluding the family home) for those aged 65 – 69 years at around $389,000. Critically, non-super assets account for over 67% of total financial wealth.

Diversification in an asset-liability framework

Putting all the pieces together, it is possible to consider retirement planning as an asset-liability matching exercise comprised of various layers as depicted below:

The aim of retirement planning becomes the attainment of a ‘retirement ratio’ of at least 100% by the preferred retirement age. Any combination of four levers can be manipulated to achieve (or maintain) fully-funded status; savings rate, retirement age, target retirement income and investment risk.

Diversification’s role changes in an asset-liability paradigm. The investment objective moves from risk/return optimisation to matching the nature, duration and variability of retirement liabilities (or needs). For couples this would ideally incorporate differing life expectancies and age pension entitlement.

There is an obvious link here to Defined Benefit (DB) retirement plans, where the provider assumes the risk of meeting a comfortable retirement lifestyle. The challenge is that these plans have been replaced by Defined Contribution plans, and this recent article made the case for retaining some DB features. In the Netherlands, where DB funds still dominate, the average pension fund has an allocation to growth assets of 24%, whilst in Australia it is around 68%. The Dutch objective is to fund long-term retirement cash flows. Australia’s focus remains primarily on accumulating lump sums payments and shorter-term investment returns.

The challenge for the Australian superannuation sector is to move from a ‘to retirement’ mindset to a ‘through retirement’ mindset within a member-centric consumption frame. As Nobel laureate and pioneer of the lifetime consumption approach, Professor Robert Merton, has opined: “sustainable income flow, not the stock of wealth, is the objective that counts for retirement planning”.

 

Harry Chemay is a Certified Investment Management Analyst who consults across both retail and institutional superannuation, focusing on post-retirement outcomes. He has previously practised as a specialist SMSF advisor, and as an investment consultant to APRA-regulated superannuation funds.

 

RELATED ARTICLES

Uncomfortable truths: The real cost of living in retirement

The impact of superannuation on retirement outcomes

Achieving a sufficient retirement income portfolio

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.