Picture this. You and your wife have worked hard all your life. You’ve raised a family, put your kids through school and paid off a mortgage. You’ve done alright financially, accumulating a combined superannuation balance of $1 million, putting you in the top 5% of retirees. Now is the time to reward yourselves for the hard slog and sacrifice over all those years, before time catches up with you and it’s too late. However you want to be sensible so you go see your financial adviser.
Now you’re the adviser sitting across the table from this couple. You congratulate them on their retirement. They’re asking about safe withdrawal rates and making sure their money lasts as long as they do. Luckily, having recently read Morningstar’s 'Safe withdrawal rates for Australian retirees' you have the answer. Their safe withdrawal rate is a dollar amount calculated as 2.5% pa of their initial retirement balance, indexed each year for inflation.
Less than the age pension
The couple does the maths and realises that this would give them an annual income (adjusted for inflation) of $25,000 pa. They say to their adviser that this cannot be right because if they had nothing they could qualify for the aged pension and receive an annual income of around $34,000 pa. The adviser helpfully points out that age pensioners also received reductions on property and water rates, energy bills, public transport and motor vehicle registration making the total pension package worth around $36,000 pa. Under the asset test changes effective from 1 January 2017, our couple would not be eligible for any age pension.
Based on a full pension package worth $36000 pa and Morningstar’s safe withdrawal rate of 2.5% pa, our couple would need a retirement balance of $1.44 million to derive an income from their account based pension that equals the aged pension. A combined balance of $1.44 million would put them in the top 2% of retirees. So unless you are advising only very wealthy clients, Morningstar’s safe withdrawal rate is of limited utility.
The gap in Morningstar’s analysis is that the minimum level of acceptable income for the self-funded retiree needs to offer more than they would receive on the age pension. Further, the definition of ‘ruin’ used to assess the safe withdrawal rate is inapprorpiate. Morningstar’s safe withdrawal rate is based on the likelihood of not running out of money. However, the 98% of retirees who’s retirement balance is less than $1.44 million would be better off (in terms of annual income) running down their account balance and becoming eligible to receive the aged pension rather than living a lifetime below the pension income.
What about an annuity?
Our couple leave their adviser’s office feeling discouraged. However, they recall seeing an amusing advertisement featuring a retired gentlemen setting off for a drive in the country in his sports car. So they look at what income they can receive with an annuity.
Our couple are both aged 65 and they consider purchasing a joint lifetime annuity with full inflation protection. The quoted rate of income is $3,109 per $100,000 investment. With their million dollar balance this equates to an annual income of $31,090. Our couple can lock in a higher annual income with a lifetime annuity than with Morningstar’s 2.5% safe withdrawal rate, but are still locking in a year one income below what they would receive on the aged pension.
Consider the ‘Rule of 5s’
What advice would I give our now woebegone couple? Try following the Rule of 5s:
- Take 5% of their account balance ($50,000 for our couple) and spend it on an overseas holiday, a renovation of their kitchen, a new car or whatever the couple desires. This satisfies a behavioral desire for a reward after years of toil. It’s also recognition of premature mortality risk. That is, the risk of dying early and leaving too much money to your children.
- Set a variable payment rate from their account-based pension at 5% of their balance recalculated each year. Taking 5% of their account balance would give our couple a first year income of $47,500, a reasonable increment on the aged pension. By making the income variable (as a % of the portfolio balance), the portfolio is more able to handle volatility in values as the drawdown adjusts to the ups and downs of the balance over time.
- Invest in a mix of growth and defensive assets with a long-term expected return of at least 5% pa. I would say a growth / defensive split of 50/50. If the portfolio can generate a return of 5% pa, with the client redeeming 5% pa, then over time the dollar value of the portfolio should be constant (although it will gradually run out of purchasing power over time due to inflation).
Ultimately, even in the unlikely event their money ran out, the age pension is a back up, after many years of enjoying a lot more from life than 2.5% offers.
Gordon Thompson has worked for a range of major financial institutions in banking and wealth management since 1999. This article is general information and does not consider the financial circumstances of any individual.