In this last installment of a four-part series, actuary John De Ravin shares some of his top tips from his recently released book on personal financial strategies.

The strategies in this article are drawn from Chapters 6 and 7 (“Pre-retirees” and “Retirees”) of my book Slow and Steady: 100 wealth-building strategies for all ages.  This article covers seven of the twenty strategies in those Chapters.

1.) Work out how long you are going to live.

You are an actuary or an actuarial student, so you recognise the multiple conceptual problems involved in simply deducting your intended retirement age (say 65) from the life expectancy at birth from the latest Australian Life Tables.  But many Australians significantly underestimate their likely life expectancy; perhaps they look at the ages at which their parents or grandparents passed away, but forget to allow for generational improvements in life expectancy.

Your remaining life expectancy depends on many variables other than age and gender.  There are at least three online life expectancy calculators that attempt to allow for some of those other variables: check out the calculators available from the MyLongevity website, AMP and the Living to 100 website.

Of course, remaining life expectancy is a mean, and about half of a sample retiree population should expect to live beyond the mean.

2.) Work out how much you need to live on.

Anecdotally, many impending retirees struggle to know how much annual income they would like to fund their regular consumption expenditure.  Of course one way to address this is to prepare a bottom-up prospective budget.  But a worthwhile alternative that might validate your budget (or replace it altogether, if you REALLY hate the budgeting process) is to look at your consumption expenditure in the years preceding retirement and adjust that for inflation and for the changes that you expect to occur at the point of retirement.  You would certainly expect some of your pre-retirement expenses to reduce (costs of travel to and from work, other expenses associated with your involvement in the workforce, mortgage commitments if they will be paid off on retirement, etc) but don’t forget to include extra costs associated with your travel or leisure activities that might increase in retirement.

3.) Work out what total amount you need to retire.

Once you have an estimate of your life expectancy and an idea of how much you need to fund your annual consumption, you can form some sensible estimate the lump sum amount you need to retire on.  This calculation is a bit easier if you expect to be comfortably self-funded (so that there is no need to allow for any age pension entitlement).  In that case, if $X is your annual consumption requirement and you expect to earn investment return at real rate r%, you can just apply a life annuity function at rate r% to$X, or alternatively use a term certain annuity factor at rate r%, with your chosen term being somewhat longer than your life expectancy to allow for the possibility that you live beyond your expectancy.

If your projected asset balance at retirement (for asset test purposes, excluding the value of your home) is less than the lower threshold for the age pension, you would probably assume you will receive the full age pension and target the retirement asset balance which will provide the difference between your target spending requirement and the age pension.

Of course if you have one-off expenditure items (or any expected lump sum receipts such as legacies) you would need to allow for those as well.

The task is more challenging if you expect your projected asset-testable balance at retirement to fall between the lower and upper threshold of the assets test because you have to allow for the impact of means testing on your pension entitlement.  In this situation you will either need to build an Excel workbook to take into account the means testing of the age pension, or alternatively rely on one of the superannuation fund calculators that project income allowing for the age pension.  A point to note if you are a pre-retiree with projected assets at retirement between the lower and upper asset test thresholds it that it is difficult to improve your sustainable retirement income (at least, until the government acts to reduce the current prohibitive 7.8% asset test taper rate) because much of your additional savings will go not to improving your retirement lifestyle but to reducing the government’s liability to pay you your part age pension.

The last paragraph of Strategy 3 above alluded to the current penal asset testing parameters.  As long as the asset test is as harsh as it currently is, there will be strong incentives for those retirees impacted by the assets test to spend down their asset testable funds until they reach the lower asset test threshold.  By so doing they increase their income as well as enjoying the benefits of their spending.  For example, they can get to live in a nicely renovated home and get more total income (because the increase in age pension receipts is likely to significantly exceed the income they would have earned on the assets that they used to hold in excess of the lower asset test threshold).

5.) Buy a prepaid funeral plan.

If you receive a part pension governed by the Assets Test, prepaying your funeral is another permissible method of putting your assets to good use and at the same time increasing your total income via an increased age pension entitlement.

6.) Drawdown at the right rate.

As noted above, if you receive a part age pension because your asset testable assets fall between the lower and upper asset test thresholds, there is an incentive to spend down quickly to maximise your age pension.  But if you are a self-funded retiree, at what rate should you spend given your financial assets?

This is really the inverse of Strategy 3 above (how much do I need to retire?) and you can apply the same approach.  Compute the annuity value for a fixed term somewhat greater than your life expectancy (maybe to age 95, for example) at the real rate of interest you expect to earn given your asset allocation.  (The target real rates of return adopted by large superannuation funds will give you a guide as to the reasonable range of real returns for your selected asset class in retirement, although the target returns are typically quoted for accumulation funds net of fees and taxes – but in retirement phase, provided that your assets are less than the Transfer Balance Cap, there should be no tax on your investment returns.)  Divide your financial assets by the annuity value you calculated.  The result of this calculation represents the average real sustainable annual expenditure.  However, if your retirement assets still include a significant proportion of growth assets that fluctuate markedly in value, you might want to consider some approach to avoiding too much volatility in your annual expenditure such as:

• Spending the calculated percentage of some sort of normalised or averaged value of your portfolio rather than the actual market value of the portfolio; and/or
• Imposing some sort of self-selected “speed limit” on your real spending increases or reductions to avoid too dramatic changes (for example, deciding to limit consumption increases or decreases to a maximum of 5% per year).

Of course, if you wish to maintain a certain level of assets for bequest purposes, or as a potential Refundable Accommodation Deposit (RAD) for an aged care facility, you would need to treat such components of your financial assets separately rather than draw down on capital maintained for those purposes.  Also you could adjust the capital available to draw down if you intend to make a substantial change to your lifestyle assets (for example, if you propose to downsize your home in future and thereby substantially increase your financial assets).

Whilst it is well known that current annuity rates are not very popular, perhaps due to the low-interest rate environment, there are still arguments for at least partial annuitisation of your retirement financial assets.  These arguments are stronger if:

1. You invest very conservatively anyway.
2. You are considering annuitizing later in life (say at age 80 or 85) where longevity risk is relatively more significant by comparison with investment risk than for young retirees.
4. You are healthy and the life expectancy calculators (see Strategy 1 above) indicate potentially longer than average expectancy.

By way of illustration of the rate of return implicit in a life annuity, assuming Australian Life Table 2010-2012 mortality rates, I estimated that the internal rate of return achieved by a 65 year-old male from purchasing an annuity (without indexation) from a leading annuity provider was 1.95% per annum and that the corresponding rate of return for a 65 year-old female was 2.6% per annum.  The true internal rates of return would be higher due to the mortality selection effect and future mortality improvements.  Whilst these rates of return are not very high, the credit risk implicit in the annuities is low, the quoted yields are better than the retirees could do by putting money conservatively in bank deposits, and by investing in this way, retirees can solve their longevity risk as well as locking in the implicit (somewhat modest) investment returns.

You can download a free list of all 100 strategies in Slow and Steady from the book’s website.

CPD: Actuaries Institute Members can claim two CPD points for every hour of reading articles on Actuaries Digital.

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