Safety revisited
Safety is as much a part of the human condition as our need for things like food, shelter and friendship, according to Maslow’s hierarchy of needs. So when it comes to you making big decisions about retirement funding there is a natural desire to seek certainty in the choices that are ahead of you. It’s similar to contemplating the pros and cons of two competing job opportunities or whether to renovate an existing home or purchase a new one. It’s the feeling of being overwhelmed by the magnitude of the choice. In the absence of facts or experience our emotion of fear of the unknown is triggered and can rule our decision making.
Investor facing retirement quite understandably can fear what lies ahead and experience emotions connected with loss of control.
Some of the biggest fears driving decisions could be framed as three simple questions:
- how can you protect your capital from running out?;
2. how can you derive income to maintain a comfortable lifestyle?; and
3. how can you maintain control and flexibility to adapt through changes?
Wanting to protect your capital makes a lot of sense. In the world of finance, the act of preserving capital is called capital protection and the risk associated with the fear of outliving your capital is called longevity risk.
There are many possibilities that can play into this fear, such as the amount of retirement capital you have, your spending habits, the current state of investment markets and the level of investment risk you are prepared to take with your capital.
These two major driving forces of capital protection and longevity can lead you down a variety of different paths. The desire for capital protection could see you deciding to invest in less riskier investments like term deposits and cash and opt to budget and live a frugal lifestyle with some capital depletion.
Or you may instead focus on combating longevity risk and allocate capital to higher risk (higher volatility) assets like shares and property with the expectation that capital growth will stretch out the years of being a self-funded retiree.
Tackling longevity risk and capital protection isn’t just solved by a mix of shares, property, term deposits or cash that best suits your needs.
You may be leaving the world of income consistency (salary) into a world of income inconsistency (investment income).
Direct Shares on the Australian Stock Exchange, which pay some of the highest incomes from all the asset classes, generally pay dividends only around twice a year.
This seems predictable enough however, just how much that dividend will be is only made public 3-4 weeks before it is paid. So even though the shareholder could achieve a high income, this approach still does not totally address income uncertainty.
And if you hold investments in cash, the changes in interest rates can either be welcome news or the signal to tighten the lifestyle budget further.
A‘bird in the hand theory’ seems to have traction in retiree share portfolios. That of course refers to a preference for dividends over capital growth because of the uncertainty associated with capital growth.
It seems fundamental sense to prefer a known outcome to a possibility of the price of an asset appreciating, but this bias to portfolios tends to reduce long term returns.
Being able to control the direction of your retirement journey and possessing the freedom to be flexible are the hallmarks of a fulfilling retirement. It can be very tempting during this new journey to let your control and flexibility be put aside because of the opinion and expectations of others (especially family) and the fear of not knowing what lies ahead.
The number of decisions a retiree could be making during this time are numerous – do you ease your way into retirement? how do you invest your money? what income do we need for your lifestyle? do we use this recommended financial product? do we downsize? how often do we holiday? The clearer you are on what is important to you, and the more you can maintain control and flexibility, the less room there is for fear to be driving your decision making.
There are many points of stress and fear-invoking elements at play here, so it is understandable if you prefer to bury your head in the sand and not worry about longevity risk, capital protection, taking on investment risk, income uncertainty, and potential loss of control.
The value of certainty is a conundrum in a world where things and people change.
In developing managed accounts, I was conscious of the need to retain the benefits associated with direct shares while negating their disadvantages. The main disadvantages were the risk of poor stock selections, the poor timing of dividends and the paperwork.
As the technology allows the investments to be held in a single H.I.N. while separately accounting for each client portfolio, it is possible to rebalance portfolios at a fraction of the cost of an individual investor doing so.
That means that instead of waiting around for dividends to be paid six monthly, it is possible to sell a fraction of each holding, thus creating the cash to meet regular withdrawals. What most people call a desire for income, is really just the cash to meet living expenses.