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17-04-2011, 09:37 AM
Apr 17, 2011
small change
Ensuring there's money for old age
Investment strategy for retirees needs to give priority to cashflow management
By Philip Loh
As we enter our golden years, we may face a different set of challenges or risks that may not have existed in the earlier stages of our lives, when our main aim was to accumulate wealth.
These risks can have a dramatic effect on our retirement income sustainability. With this in mind, let us explore one of these risks, called the 'sequence of returns' (SOR) risk.
Many senior citizens are aware that they are too old to start taking risks, mainly because they will not have the time to recover if they incur huge unexpected losses.
This is commonly referred to in financial planning circles as SOR risk. It is precisely because of this risk that I am often more cautious when recommending entry strategies for investors who are nearing retirement or already retired.
SOR risk emerges as we approach retirement
SOR risk is a very real one as we approach retirement, and failure to consider it could derail our retirement goals. This is because during the 10 years just before and after retirement, which I dub the 'vital risk period', an investor's assets are most sensitive to the damage from negative market returns. We call this 'sensitivity to poor returns SOR risk', which primarily arises from two critical factors.
First, the bulk of our funds is at stake just prior to and after retirement. As a result, the effect of dollar cost averaging - an investment strategy of investing equal amounts regularly to lower the overall cost of the investment - during this stage is limited.
And second, the impact of withdrawals magnifies the damage from initially poor returns after retirement. If negative or poor returns are experienced early on in retirement, the sustainability of our targeted retirement income will be threatened.
For example, let's assume you retired in early 2000 with a nest egg of $1 million. As the global stock markets had chalked up spectacular returns in the preceding 10 years, your financial adviser may have asked you to invest your $1 million in a global equity fund, with an expected return of 8 per cent per annum (reasonable at that time given the historical returns for global equity we were looking at then) and an annual withdrawal of 6 per cent ($60,000) to finance your retirement.
In this example, the bursting of the Internet bubble in 2000 would have obliterated a big chunk of your nest egg, while the ensuing credit crunch in 2008 would have wiped out your money totally. So, even though the market did rebound strongly in the subsequent two years, you would have had no capital base left to take advantage of the recovery.
How to insure against SOR risk
To avoid SOR risk, you should first manage your cash flow prudently, and then diversify your assets.
Financial advisers have long preached the importance of asset diversification to manage risk. This established doctrine is based on well-cited studies, which have found that asset allocation is the single-most important driver of investment returns, far outweighing the importance of selecting individual securities.
But once it is time to retire, and the withdrawal of income from your accumulated assets starts, the role of asset diversification diminishes in importance and cashflow management emerges instead as the core focus.
In short, to manage SOR risk during retirement, income planning surpasses asset allocation in importance, when success is measured in terms of lifetime income sustainability.
While a diversified portfolio of stocks and bonds will be important regardless of age and the stage of life that you are in, it is cashflow management that will take centre stage during retirement.
After all, the greatest fear of all retirees is that their money runs out before they die. They typically do not care what the investment return is, as long as their retirement income objective is met. Sacrificing 1 percentage point to 2 percentage points in compound returns to insure their retirement plan from failure seems to be the right thing to do for most.
The retirement income approach that I often advocate is designed to positively increase the chances that retirees can receive a sustainable retirement income throughout their lifetime. It involves a simple strategy of utilising a series of products to ensure stable periodic income payouts for their retirement lifestyle needs, and also to satisfy their legacy requirements.
Cashflow instruments to manage SOR risk
Apart from the core portfolio of bonds and equity funds, I usually suggest that older clients use a combination of three categories of cashflow instruments for the more liquid portion of their retirement portfolio. These are:
1. Short-duration endowment plans involving different maturities and payout sequences;
2. Singapore Government Bonds with two years to 10 years left to maturity; and
3. Fixed deposits or just plain vanilla saving accounts.
It is best for individuals and their advisers to determine the exact allocation and investment vehicle mix that will both balance their SOR risks and achieve their legacy planning goals.
Just as we have no control over the precise length of our golden years or the rate of inflation during our retirement, we also cannot control the timing of an inevitable bear market. Thus, rather than trying to predict when a bear market will strike, I believe we should just insure ourselves against adverse outcomes by using appropriate cashflow strategy.
In short, our objective should be to simply hedge against SOR risk, while keeping in mind our retirement income goals.
The writer is a chartered financial consultant and executive manager of financial services with Great Eastern Life. The views expressed are his own. Comments are welcome at http://www.opl.sg/contact.html#feedback
small change
Ensuring there's money for old age
Investment strategy for retirees needs to give priority to cashflow management
By Philip Loh
As we enter our golden years, we may face a different set of challenges or risks that may not have existed in the earlier stages of our lives, when our main aim was to accumulate wealth.
These risks can have a dramatic effect on our retirement income sustainability. With this in mind, let us explore one of these risks, called the 'sequence of returns' (SOR) risk.
Many senior citizens are aware that they are too old to start taking risks, mainly because they will not have the time to recover if they incur huge unexpected losses.
This is commonly referred to in financial planning circles as SOR risk. It is precisely because of this risk that I am often more cautious when recommending entry strategies for investors who are nearing retirement or already retired.
SOR risk emerges as we approach retirement
SOR risk is a very real one as we approach retirement, and failure to consider it could derail our retirement goals. This is because during the 10 years just before and after retirement, which I dub the 'vital risk period', an investor's assets are most sensitive to the damage from negative market returns. We call this 'sensitivity to poor returns SOR risk', which primarily arises from two critical factors.
First, the bulk of our funds is at stake just prior to and after retirement. As a result, the effect of dollar cost averaging - an investment strategy of investing equal amounts regularly to lower the overall cost of the investment - during this stage is limited.
And second, the impact of withdrawals magnifies the damage from initially poor returns after retirement. If negative or poor returns are experienced early on in retirement, the sustainability of our targeted retirement income will be threatened.
For example, let's assume you retired in early 2000 with a nest egg of $1 million. As the global stock markets had chalked up spectacular returns in the preceding 10 years, your financial adviser may have asked you to invest your $1 million in a global equity fund, with an expected return of 8 per cent per annum (reasonable at that time given the historical returns for global equity we were looking at then) and an annual withdrawal of 6 per cent ($60,000) to finance your retirement.
In this example, the bursting of the Internet bubble in 2000 would have obliterated a big chunk of your nest egg, while the ensuing credit crunch in 2008 would have wiped out your money totally. So, even though the market did rebound strongly in the subsequent two years, you would have had no capital base left to take advantage of the recovery.
How to insure against SOR risk
To avoid SOR risk, you should first manage your cash flow prudently, and then diversify your assets.
Financial advisers have long preached the importance of asset diversification to manage risk. This established doctrine is based on well-cited studies, which have found that asset allocation is the single-most important driver of investment returns, far outweighing the importance of selecting individual securities.
But once it is time to retire, and the withdrawal of income from your accumulated assets starts, the role of asset diversification diminishes in importance and cashflow management emerges instead as the core focus.
In short, to manage SOR risk during retirement, income planning surpasses asset allocation in importance, when success is measured in terms of lifetime income sustainability.
While a diversified portfolio of stocks and bonds will be important regardless of age and the stage of life that you are in, it is cashflow management that will take centre stage during retirement.
After all, the greatest fear of all retirees is that their money runs out before they die. They typically do not care what the investment return is, as long as their retirement income objective is met. Sacrificing 1 percentage point to 2 percentage points in compound returns to insure their retirement plan from failure seems to be the right thing to do for most.
The retirement income approach that I often advocate is designed to positively increase the chances that retirees can receive a sustainable retirement income throughout their lifetime. It involves a simple strategy of utilising a series of products to ensure stable periodic income payouts for their retirement lifestyle needs, and also to satisfy their legacy requirements.
Cashflow instruments to manage SOR risk
Apart from the core portfolio of bonds and equity funds, I usually suggest that older clients use a combination of three categories of cashflow instruments for the more liquid portion of their retirement portfolio. These are:
1. Short-duration endowment plans involving different maturities and payout sequences;
2. Singapore Government Bonds with two years to 10 years left to maturity; and
3. Fixed deposits or just plain vanilla saving accounts.
It is best for individuals and their advisers to determine the exact allocation and investment vehicle mix that will both balance their SOR risks and achieve their legacy planning goals.
Just as we have no control over the precise length of our golden years or the rate of inflation during our retirement, we also cannot control the timing of an inevitable bear market. Thus, rather than trying to predict when a bear market will strike, I believe we should just insure ourselves against adverse outcomes by using appropriate cashflow strategy.
In short, our objective should be to simply hedge against SOR risk, while keeping in mind our retirement income goals.
The writer is a chartered financial consultant and executive manager of financial services with Great Eastern Life. The views expressed are his own. Comments are welcome at http://www.opl.sg/contact.html#feedback
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