‘You keep this up and we’re going to fast run out of friends,’ said my wife
‘They asked for my opinion,’ was the only I defence could mount.
‘I know, but you don’t have to shatter their dreams.’
‘Sorry, but what do you want me to do? Lie?’
‘No, of course not,’ was Linda’s response.
And there endeth the conversation.
The background is some friends of Linda’s family have recently sold their home in Brisbane. They are both in their early 60s (not yet eligible for the age pension). Both are sick and tired of working.
The plan is to move to Tasmania, buy a cheaper property and put the surplus cash (approx. $250k) into their super as a non-concessional contribution. By the way, they don’t know a soul in Tasmania, and all their family live around south east Queensland.
All up they’ll have about $600k in their super — an industry fund.
They have been to the industry super fund financial planner and been given the thumbs up on their retirement plan. The projections show they can generate a tax free income from an account based pension that is sufficient to fund their lifestyle.
In a few years’ time they’ll be eligible for a part-pension. Life’s sweet.
They asked for my opinion on their plan. I asked if they wanted an opinion on the financial plan or the grand plan.
‘The grand plan.’
Having lived in Cairns for 23 years I’d seen plenty of people fall in love with the easier lifestyle, lower cost housing and the beauty of the region.
Some stayed. Most left. The reasons varied from ‘it’s too hot,’ ‘we miss family and friends,’ ‘we miss the excitement of a bigger town,’ and in some cases their partner died.
From my experience there are long odds on a successful long term transition to a quieter, lower cost and more picturesque location.
The cost of re-location — buying and selling property, removalists, etc. — is not cheap.
In addition to that, trying to buy back into a higher priced location can be a very costly exercise. Or you end up settling for something far inferior to what you gave up.
‘Perhaps,’ I said somewhat optimistically, ‘you may be part of the minority that goes the distance.’
Then they showed me their financial plan.
The recommendation was to invest 15% of their superannuation into cash (as a buffer) and the remainder into the balanced fund.
They intend drawing $36,000 — 6% per annum — to cover living costs. They don’t live the high life and are fairly resourceful. They grow their own veggies, have fruit trees and make jam.
I still thought the number was a bit light, but they’re certain it’ll cover their needs. OK, who am I to argue?
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The balance fund has a long term track record (30 years) of delivering around 10% per annum. But to err on the side of caution the projections were based on 7%.
The graph looked pretty. A slight upward movement initially. Then it moves higher still when they are eligible for the age pension, as the payment from their account based pension can be reduced to 5% per annum.
The graph starts to arc down when they are in their late 70s/early 80s, but they’re not too worried about that.
Balanced funds have around 65% exposed to Australian and International shares. The rest is allocated to property, fixed interest, infrastructure, private equity and cash.
Since 1982, the Australian share market has increased by at least 1200% — even accounting for the ‘87 crash, dotcom bust and the GFC. It has been a truly phenomenal period of performance. Without peer in the 140-year history of our market.
Is it just coincidence that this exceptional period of performance just happened at the same time the world embarked on the biggest debt binge in history? Or do you think there may be some cause and effect going on here?
If we have another and far more serious debt crisis, then what do you think is going to happen to the share market? The same cause and effect, but in reverse.
The 10% per annum average performance over the past 30 years means diddly, unless of course we have an exact repeat of the economic conditions that produced that result, for the next 30 years.
Unfortunately the plan’s pretty graphs never factor in the impact of negative returns — more on this later.
The plan also doesn’t factor in the very real likelihood of significant change to age pension entitlements. A fifth grader with a basic grasp of math can figure out Governments cannot continue to pay age pensions to people for 30, 40 or with improvements to medical science, possibly up to 50 years.
My brutal assessment was they are likely to be penniless by the age of 75 and will live the remaining 20 years of their life in poverty.
How can I say that?
First you need to read the section in my book The End of Australia that shows you how a couple of relatively negative years can destroy your capital base in an account based pension. Here’s an extract with some of the detail:
Whereas if you’re over 50, and especially if you’re eligible to commence an account based pension, you have some serious decisions to make on how much of your capital to expose to an asset class that appears to have more risk than reward.
Superannuation is the savings and accumulation vehicle of choice for most Australians. The tax regime of 15% tax on earnings in the accumulation phase and 0% tax in the pension phase is too attractive to ignore.
Assuming most people over 50 have a reasonable amount of retirement capital invested in superannuation, it’s also then fair to assume that most will convert this accumulated capital into an account based pension (formerly known as an allocated pension).
Financial planners love account based pensions. Why? What better way to promote a product than to tell a client, ‘You won’t pay any tax if you invest in this.’
The tax advantages are true, but nothing is ever one dimensional in the investing world.
Let me show you what would have happened if you’d retired in June 2007 (when share markets were still going strong) and invested in the industry preferred diversified choice of the ‘balanced fund’.
You place your trust in a responsible planner. They recognise the market’s looking a bit toppy in 2007. To offset the prospect of any downturn in the market, they follow the theory — as set out in the textbooks — on how to construct a prudent, account based pension portfolio.
The textbook says to place four years’ worth of drawdowns in cash and the balance in ‘growth’ assets. This way you can draw off the cash balance while the ‘growth’ assets are quarantined for at least four years. In theory, this is sufficient time for the growth assets to recover from any market setbacks.
Here’s our example based on $500,000 to invest and a $25,000 per annum drawdown.
For the purpose of the exercise, I’ve used performance data supplied by SuperRatings.
Below is the median annual return for balanced funds over the past seven financial years:
- 2007/2008 financial year: negative 6.4% (loss)
- 2008/2009 financial year: negative 12.7% (loss)
- 2009/2010 financial year: 9.8% (gain)
- 2010/2011 financial year: 8.7% (gain)
- 2011/2012 financial year: 0.4% (gain)
- 2012/2013 financial year: 14.7% (gain)
- 2013/2014 financial year: 12.7% (gain)
The table below shows the outcome if we apply the above performance figures to our $500,000 investment — $100,000 in cash (four-year buffer) and $400,000 in balanced fund — and assume a drawdown of $25,000 per annum (not indexed) for living expenses.
(Note the $100,000 cash buffer plus interest earned exhausts the cash buffer after 4.5 years. Therefore, halfway through year five we need to draw on the balanced fund to pay our retiree their income.)
After seven years our starting $500,000 is now worth $436,960 (the cash buffer expired in early 2012).
The account balance would be much lower if the drawdown had been indexed (which happens in reality). In addition, if a planner was involved, there would also be establishment and ongoing fees deducted from the account balance. What we see above is a ‘best case’ scenario.
The fact is if your account based pension gets hit early by negative returns, it’s unlikely you’ll ever recover your starting position.
As you can see, the impact of two negative years has not been offset by five positive years. And in the context of negative returns, minus 6.4% and minus 12.7% are not all that catastrophic.
The odds are our family friends will move back to south east Queensland in the next five or so years.
It’ll likely cost them $200k or more to buy back into a suburb that is inferior to the one they left.
I doubt they’ll heed my advice — it is too hard to comprehend, and doing so would shatter the dream — so their account based pension is going to be smashed when the next crisis hits. If they’re lucky, they may have $400k left, but my gut tells me it will be less. Take out the $200k for the home purchase and there isn’t much left to supplement any age pension they may receive.
And whatever is left has to last them (one or both) possibly until well into their 90s.
This is not the retirement dream they had in mind.
And I think this is going to be an all too familiar outcome in the coming decade.
Optimistic forecasts are going to be replaced by pessimistic realities.
The markets do not care what station of life you are in. They show absolutely no mercy when they are in the mood to correct imbalances.
What is the answer for our friends? Stay in the workforce longer.
Anyone else want to invite me to a party?
Editor, Markets and Money
PS: As I’ve mentioned this week, I wrote The End of Australia on the urging of my colleague Bill Bonner. In effect, it is a localised companion to a book Bill himself wrote last year.
When I met Bill in Paris earlier this year he graciously offered that I make this book available to any Australian who requests it as well.
It’s called Hormegeddon: How Too Much of a Good Thing Leads to Disaster.
If you want to understand EXACTLY what is wrong with the global financial system right now…and what the next big crisis will look like on a global level…you MUST read this book.
Drawing on stories and examples from throughout modern political history — from Napoleon’s invasion of Russia to the impending collapse of the American healthcare system — Hormegeddon sets out to understand one thing:
How good things turn bad.
See, history is not a clean yarn spun by its victors.
It is a long tale of things that went wrong — debacles, disasters, and catastrophes.
Bill Bonner realised that each disaster carries with it a lesson.
For instance…if the architect of a great liner tells you that ‘not even God himself could sink this ship’…you should probably take the next boat.
If the stock market is selling at 20 times earnings and all the expert analysts urge you to ‘get in’ because you ‘can’t lose’…you should probably get out.
Similarly, if a country has gone nearly a quarter of a century without a recession…you should probably expect an equally remarkable counter-reaction.
That is the core theme of Bill Bonner’s Hormegeddon.
It’s a must-read. And it’s yours to download as well…also for free.
Editor, Markets and Money