19 Aug, 2019
By, Dermot Ryan
Once elected, one of the first things the new Morrison Government announced was a review of the retirement income system.
The review was proposed due to the increasing complexity of the current system and the challenges brought about by higher life expectancies, the impact of low interest rates and the lack of income available in many asset classes due to current lofty valuations.
In what will be a broad-based review it will look across the key tools to generate an adequate retirement income: the age pension, superannuation (including compulsory contribution levels) and savings outside super.
It will also address some divisive topics such as potential changes to the tax treatment of retirement savings, the role of the family home in retirement, and super contribution limits. It is quite an ambitious agenda that will give retirees and financial advisers much to think about in the months ahead.
Until we hear more about the direction of this review, we thought it would be interesting to take a look at the challenges of generating a reasonable income in retirement. When investing with a goal – such as retirement – in mind, it pays to think long-term. But there is no escaping the realities, and challenges, of today’s investment environment for retirees.
Impact of interest rate changes and high valuations
Interest rates have an impact on the investment landscape when they are low as well as high. Currently, interest rates are as low as they have ever been and this has driven valuations of defensive assets to unprecedented highs.
High valuations mean low yields and we are seeing record-low yields across many fixed income assets and some types of property. Term deposit rates are also at fresh lows following the Reserve Bank of Australia’s decision at its July meeting to drop the cash rate to one per cent, with expectations of more cuts to come later this year.
Low interest rates affect variables such as inflation and investment returns, and as such they have consequences for investment products. This has flow-on effects to all asset classes and, in turn, affects every Australian worker’s ability to save for retirement.
In the past, we had more options as investors – in the high interest rate era of the late 70s and 80s even relatively low-risk assets like term deposits and bonds offered double-digit returns. These days rates of return are all closer to one per cent.
Similarly, property yields in Australia are around two to four per cent depending on the type of property and geography.
Yields on Australian equities are still at 4.3 per cent before franking and about 5.5 per cent including franking. This shows that better yields are available but investors must either accept the valuation risk of defensive assets or take on more earnings risk in growth assets like equities, perhaps alongside a higher cash allocation.
The inflation perspective
Inflation has a big impact on retirees as they are in less of a position to accumulate capital after their working lives have finished. Falling returns mean providing for retirement is challenging, but although returns are low now compared to in the past, the view is not as bad when inflation is considered.
Inflation was running at around 15 per cent in the late 70s and 80s, which ate up much of the bond and term deposit returns mentioned above.
With inflation currently sitting at 1.8 per cent in Australia and returns for an average diversified fund at seven per cent, real returns don’t look so bad compared to two decades ago, taking into account the higher inflation levels of the time. Nevertheless, the combination of low interest rates and low inflation create a challenging returns environment for retirees.
There are risks too, should the current global inflation rate of about three per cent ever break higher than the defensive asset classes. As these assets are priced for the very low inflation of today, they would face major negative revisions. A reason, perhaps, to reduce valuation risk with a bar belled approach, increasing both cash and some growth assets.
The longevity conundrum
With Australians now living longer, another risk to retirement savings is longevity risk – the risk a retiree will outlive his or her savings. Back in 1980, a man starting a pension at age 65 had a life expectancy of 78 – an additional 13 years. Now, a male starting a pension at 65 has a life expectancy of 86 – an additional 21 years. While this is great news in many ways, it poses challenges financially as there are higher income needs as well as the need to grow the assets over time to make up for rising costs of living.
This is a particular concern in an environment which sees retirees drawing down on their pool of retirement assets because they can no longer generate sufficient income returns. This means retirement account balances are being depleted relatively quicker than in the past, especially if retirees lack exposure to growth assets to generate some capital growth over their longer lives.
No easy solutions
Supporting an ageing population to achieve their retirement goals in a market of lower investment returns is one of the major challenges facing our society and financial services businesses. A stable policy framework for superannuation and a long-term approach will be important in giving retirees the best chance of achieving a comfortable retirement.