SCOTT FRANCIS – 15 JULY 2013

Summary: Modelling of superannuation outcomes demonstrate the extent of the hit taken by retirees hit by economic crises soon after finishing work in the early 1970s, compared to those who retired after the energy crisis. The worst, most share –exposed outcomes saw retirees run out of money well before expectations, while the best gave the retiree 17.45% returns.

Key take-out: A balanced superannuation portfolio is clearly the only investment strategy that met expected 30-year returns in both crisis and post-crisis economies, according to our modelling.

A couple of weeks back I put together a model of what a 30-year retirement looked like for someone who retired in 1983, and had lived until now (Going for growth, a 30-year retirement plan). The basic thinking was that many of us would target a 30-year retirement (say retire at age 55 to 60 and live until age 85 to 90), and the article investigated how would that have worked out using what had actually happened over the past 30 years.

This article takes a different approach, and looks at a period of time that has similarities to the Global Financial Crisis period, looking at what would have happened for people who started a 30-year retirement either side of that crisis. The period in time I have looked at is the 1970’s crisis, which saw some similarities to the GFC period, including sharp stockmarket falls, an energy crisis and a recession in many parts of the world. Of course there were many differences – for example the GFC period has not had the high inflation that was so prominent over the 1970s period.

The ‘pre-crisis’ retirement will be considered to start at the beginning of 1973, starting at a time when stockmarkets fell more than 50% in value over 2 years. The ‘post-crisis’ retirement will start at the beginning of 1975.

We will assume a number of key inputs, including:

1. The retirees will pay no tax (similar to what we see in the current retirement landscape).
2. In the first year they will draw on their assets at 70% of the average wage (measured by AWOTE – Average Weekly Ordinary Time Earnings).
3. Each year they will increase their retirement drawings by the rate of inflation (inflation data is from the RBA website).
4. They will start with assets equal to 20 times their first years drawings (I think having 20 times your drawings is a reasonable target for someone looking to build retirement assets).
5. We will compare three investment approaches for both the ‘pre crisis’ and ‘post crisis’ retirements being: 100% invested in Australian shares; 100% invested in cash; and 50% invested in cash/50% invested in Australian shares.

Starting point – ‘pre-crisis’ retirement

This is the retirement scenario that starts at a very difficult time – much like a retiree who began their retirement at the start of the Global Financial Crisis. At the start of 1973, the average full-time income (AWOTE) was $5054.  In our model retirement income will start at 70% of this figure, $3538, and increase by inflation each year. Retirement assets will start at 20 times the initial drawing of $3538, or $70,761.

The first assessment strategy that we look at considers investing 100% of their assets in cash. This has the initial advantage of avoiding the terrible stockmarket years of 1973 and 1974, which saw stockmarket falls of 26% and 24%.  This investment allocation worked reasonably well over the period, seeing the retiree increase their income each year by inflation and only running out of assets in 2001 – just before the end of their 30-year retirement. It should be noted that there were some pretty exceptional years of cash returns (including seven years of returns of more than 15%), however there were also some years of high inflation that increased the income being drawn from the retirement portfolio.

The second assessment strategy was a 100% share investment. Two terrible years of stockmarket returns to start with (-26% in 1973 and -24% in 1974), and the drawing of retirement income from the portfolio, meant that by the start of 1976 the stockmarket portfolio that was initially valued at $70,761 had fallen in value to $32,768. Because of inflation, the annual drawing had increased to $4719, or nearly 15% of the portfolio’s value. By comparison, the cash portfolio was valued at $73,361 at the same point in time. The stockmarket portfolio never recovered, and after 20 years it ran out of funds.

The third strategy – 50% shares and 50% cash provided an interesting result. We have to add another important assumption, which is that each year the portfolio is ‘rebalanced’ back to a 50% shares/50% cash balance. This portfolio strategy is the only one that actually ‘survives’ the 30-year period, and provides the annual income that started at 70% of AWOTE and increased each year with inflation. In fact, at the end of the 30-year period (the start of 2003) there is still $35,700 left in the portfolio.

It is interesting to reflect on why this has happened. Neither cash or Australian shares provided sufficient investment returns to completely fund a 30-year retirement, so how could a mix of the two provide a better outcome? The short answer is that having cash in the portfolio in the early days helped reduce the massive loss of capital that the stockmarket portfolio had in its first two years (where it was reduced to $32,768 from a starting balance of $70,761), while still allowing it to benefit from some of the years of very high returns from Australian shares (Over this period there were seven years when annual returns were in excess of 40%, with a return of 66.8% in 1983.) 

The post-crisis retirement

This retirement avoided the terrible stockmarket returns of 1973 and 1974, and starts at the beginning of 1975.  At this time average wages have moved on to $7,482, meaning that starting out, retirement income was 70% of this, or $5,237 and the starting portfolio balance was 20 times the starting retirement income, or $104,759.

The results from this portfolio are somewhat less interesting by themselves. The 100% cash strategy sees a final balance, after 30 years, of $329,000. The 100% Australian shares strategy sees a final balance of a very impressive $4.3 million (the average return over this period was a very impressive 17.45% a year, well above historical long-run averages). The 50% cash and 50% Australian shares strategy provided an end balance of $3.88 million – and impressively strong result brought about through the reduced portfolio volatility that the cash offers, but still some years of very high returns (31% and 35% in 1985 and 1986 respectively). 

The 100% Australian share portfolio over this period had a return of 17.45% a year, with a standard deviation of returns (a measure of how volatile the portfolio was) of 23.25%. The 50% Australian shares and 50% cash portfolio had an average return of 13.84% with a much lower standard deviation of returns of 11.9% - allowing a greater compounding of returns. Both of these figures (17.45% return for Australian shares and 13.84% for a half cash/half Australian shares portfolio) is significantly above historical averages. 

Conclusion

It is interesting to consider the impact of an economic crisis on someone retiring. The results of the scenarios we have considered here reinforce the impact that the early years of retirement can have. Tough early years put significant financial pressures on retirement plans, whereas a good start leads to very satisfactory outcomes.

The importance of a mix of cash and shares in a portfolio is supported by the modelling done in this exercise. It is the only of the three options to fund a 30-year retirement starting in 1973, and also allows a very attractive return with reasonable volatility in the 1975 model.

It should also be noted that these scenarios are very ‘static’ in their assumptions. For example, they don’t allow for a reduced level of income being taken during bad years. It also ignores the important safety net of the age pension that we have in Australia.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.