The Two Phases of the Superannuation Cycle

Are the markets testing your nerves? As my fellow editor, Greg Canavan, wrote last week in Sound Money, Sound Investment., eight months of gains have been wiped out in the space of a few weeks. The once solid market mountain has turned into a slippery slope.

Yesterday, we showed you ‘heartbreak hill’ — the Nikkei 225 index since 1985.

Today, we show you the ‘money mountain range’. Since 1985, the All Ordinaries index has been in the ascendency. There’s gold in them there hills!

Nikkei 255 index stock market
Long term ‘climbers’ have been through a few gullies (1987, 2000–2003 and 2008–09). But overall, they’ve fared pretty well.

Perhaps the market’s current slippery slope will find a solid ledge…enabling it to regain its footing for an assault on the 2007 peak…OR it continues to fall deeper into the valley of unknown losses.

No one knows for sure what the near term topography of the market is going to be. However, it’s a pretty safe bet that in a 100-years’ time, the market will be at a much higher altitude.

What’s that? You’ll be dead in 100 years? Precisely. That’s my argument with the industry’s repetition of ‘the markets always go up in the long term’. But the question for individual investors is whether they go up while they’re alive.

There’s a mismatch between the industry’s time horizon (investment institutions will continue long after we’re but a memory) and investors requiring capital to finance their lifestyle in the coming years.

The investment industry focusses your eyes on the next peak. In the long term, we are told, share markets always go up. Hang in there. Promised riches await. Without this promise, their business model is under threat.

But what happens if you fall down a ravine while staring skyward and suffer ‘injuries’ that prohibit you from partaking in the hike to the promised peak?

This is the reality those approaching and those already in retirement must seriously consider. You may recall yesterday’s Daily Reckoning included a reader email from John, a senior executive with an international investment institution. Here is an excerpt (emphasis is mine):

If it was the correct strategy to invest a high proportion in equities while accumulating a super fund, my view is it remains appropriate to hold a high proportion in equities approaching and post retirement. Perhaps risk exposure should be reduced when life expectancy reduces to 10 years or less — and when valuation ratios tell us so clearly the market is overvalued as they do now.

John does place a caveat on whether you should hold or not hold a high proportion in equities into retirement when he says ‘Perhaps risk exposure should be reduced…when valuation ratios tell us so clearly the market is overvalued as they do now.

The fact is (and I can tell you this from my experience) your average mum and dad investor would not have a clue about market valuation. In fact, when you look at the funds flow data — pouring in as markets boom and pouring out when they bust — you can only conclude they are the worst possible valuation judges (along with the financial planners who advised them).

When you reach the retirement phase of your superannuation lifecycle, you must remain vigilant about where you invest.

Here’s why.

Say, you spent a working life accumulating funds in the standard balanced portfolio — 60% in shares (Australian and International), 20% in property and alternatives (hedge funds, infrastructure), and 20% in fixed interest (bonds) and cash. But now it’s time to switch from the accumulation phase to the pension phase.

What do you do? Stay with the balanced fund? Increase the share exposure from 60% to nearly 100%? Reduce share exposure? You’ll have to wait for the answer.

First, the most tax effective retirement income stream is delivered via an account based pension (previously termed an allocated pension). This is the second phase of the superannuation lifecycle.

Let me show you what happens if you had retired in June 2007 (when markets were still going strong) and stayed with the tried and true balanced fund.

You see a responsible planner, who recognises in 2007 that the market looks a bit toppy. Therefore, to offset the prospect of an imminent downturn, they follow the text book approach on how to construct a prudent, account based pension portfolio.

The text book says we should place four years’ worth of drawdowns in cash and the balance in ‘growth’ assets. This way the retiree 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 (no indexation).

For the purpose of the exercise, we’ll use performance data supplied by SuperRatings.

Below is the median annual return for balanced funds over the past seven financial years:

  1. 2007/2008 financial year: negative 6.4% (loss)
  2. 2008/2009 financial year: negative 12.7% (loss)
  3. 2009/2010 financial year: 9.8% (gain)
  4. 2010/2011 financial year: 8.7% (gain)
  5. 2011/2012 financial year: 0.4% (gain)
  6. 2012/2013 financial year: 14.7% (gain)
  7. 2013/2014 financial year: 12.7% (gain)

If we apply the above performance figures to our $500,000 investment — $100,000 in cash (4-year buffer) and $400,000 in balanced fund — and assume a drawdown of $25,000 per annum (not indexed) for living expenses, we have the following outcome.

Please note that the $100,000 cash buffer + interest earned exhausts the cash buffer after four and a half years. Therefore, halfway through year five we need to draw on the balanced fund to pay our retiree their income.

Here’s how our retiree’s balanced fund has performed:

Year Start Amount of Balanced Fund Performance Balance Less
Annual Drawdown
End of year balance of Balanced Fund
07/08 $400,000 Minus 6.4% $374,400 Nil $374,400
08/09 $374,400 Minus 12.7% $326,850 Nil $326,850
09/10 $326,850 Plus 9.8% $358,880 Nil $358,880
10/11 $358,880 Plus 8.7% $390,100 Nil $390,100
11/12 $390,100 Plus 0.4% $391,660 $12,500 $379,160
12/13 $379,160 Plus 14.7% $434,900 $25,000 $409,900
13/14 $409,900 Plus 12.7% $461,960 $25,000 $436,960

After seven years, our initial $500,000 is now worth $436,960 (the cash buffer expired two and a half years ago).

The account balance would be much lower if the drawdown was indexed (which does happen 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 in the beginning has not been negated by five positive years.

Starting an account based pension on a ‘slippery slope’ makes it difficult to ever regain your footing.

Conversely, if you had stayed in cash for the past seven years, earning an average of 4% per annum (some years higher and others lower), the balance would be around the mid $400,000s.

In theory, the four year cash buffer is the solution to the volatility problem. However, from the bitter experience of working through the 1987 crash, the Tech Wreck and the GFC, I can tell you the theory does not always work.

To demonstrate just how slippery the slope can become, let’s say the next two years are an exact replica of 07/08 (minus 6.4%) and 08/09 (minus 12.7%).

Year Start Amount of Balanced Fund Performance Balance Less
Annual Drawdown
End of year balance of Balanced Fund
14/15 $436,960 Minus 6.4% $408,995 $25,000 $383,995
14/15 $383,995 Minus 12.7% $335,230 $25,000 $310,230

For the record, in the scheme of stock market negativity neither of these annual returns are particularly catastrophic…but look at the outcome — $436k to $310k in two years.

Just when you think you’re climbing your way back, down comes a (rather modest) avalanche and you fall further into the ravine of despair.

Imagine what the outcome would be if we have a GFC MkII that absolutely annihilates markets.

If the above scenario does unfold, you’ll be sitting there thinking you everything right.

Four year cash buffer. Tick.
Growth assets for the long term. Tick.
A professionally managed balanced portfolio. Tick

Yet, you’ve lost 40% of your retirement capital (add in inflation and adviser fees and it would be closer to 50%) over a nine year period. It wasn’t meant to be this way. The investment industry assured you that over the long term the markets would reward me. Surely, nine years is a long enough term. Not so.

Accumulating (saving on a regular basis) into a falling share market is an excellent way to build wealth. Your dollar buys more units in the growth fund.

Retiring (drawing a regular pension) in a falling market is a disaster for your capital. More units need to be redeemed to fund your pension payment. The longer the period of negativity, the more your pool of units dwindle. When the recovery eventually comes, you have precious little of your retirement capital left to participate in the assault on the peak.

You are destined to dwell in the valley of despair.

In my opinion, the Fed has constructed a paper bridge across the ravine that separates the 2007 peak from the 2014 peak. As more people are persuaded to embark on the journey to the land of promised riches, the paper bridge is likely to collapse under the weight.

The fall into the abyss below will destroy a lot of retirement dreams.

On this point, I agree with Johnthat‘valuation ratios tell us so clearly the market is overvalued as they do now’.

There are times in the investment cycle to be cavalier and times to be cautious. For those approaching retirement, now is the time for the latter.

Tomorrow, we’ll look at how you can take control of your retirement account.


Vern Gowdie+
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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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