Traditional risk profiling, the process of matching investors to portfolios based on their appetite for volatility, has been a cornerstone of financial advice for decades.
The conventional wisdom was that older investors should automatically shift into defensive assets, as protection of capital was the primary objective in retirement. But as a new generation of wealthier, self-funded retirees emerges, this old school thinking is starting to show cracks. The default defensive position may no longer fit the modern retiree, who could live another 25 to 30 years and need their capital to generate income while outpacing inflation to preserve buying power.
What traditional Risk Profiling is and why it made sense
Volatility – the ups and downs of market values – is the price we pay in exchange for investment returns. Risk profiling traditionally categorises investors by how much volatility they are prepared to accept in pursuit of those returns.
At one end of the spectrum sit conservative or defensive investors, who prefer cash, term deposits, and fixed interest investments. These offer stability but limited growth. At the other end, high growth investors embrace the volatility that comes with owning assets like shares and property, understanding markets rise and fall but tend to reward patience with higher long-term returns.
Depending on an investors time frame, funds invested, earnings capacity, general knowledge and sentiment around markets, a blend of investments is chosen that captures the right balance between sometimes competing priorities.
The traditional “life cycle” risk profiling theory was that younger people should start their journey with a high growth focus, accepting more risk to capture growth, gradually scaling back then blend into a more balanced approach as they moved into middle age, and eventually shifting into defensive mode in retirement for stability and predictability. For decades, this approach aligned neatly with the realities of retirement – limited savings, reliance on the Age Pension, and modest financial goals. Indeed, many large super funds automatically aligned risk profile with age as a default, one size fits all approach.
Meet the Modern Retiree and why the old rules don’t fit
But today’s retirees are different. We’ve had compulsory superannuation for over 30 years and many are retiring with larger superannuation balances, owning their homes outright, and no longer qualifying for the Age Pension. They are healthier, more active, and often expect a retirement to last decades, not years, with a much higher lifestyle standard.
According to data from the Association of Super Funds of Australia (ASFA), Australians aged 65 – 69 have an average superannuation balance of around $400 000, with the median closer to $200 000. For those in that group, who may still use some of the proceeds to pay off the rest of their mortgage, their superannuation generally serves as a supplement to their Centrelink pension or emergency funds for big, unexpected expenses. Capital preservation and liquidity are critical when funds are limited. In this case, the traditional model of defaulting to defensive assets may be appropriate.
However, many self-funded retirees have balances well above that, and certainly more than the $1 030 000 in combined assets at which point a couple no longer qualifies for Centrelink. These investors are not parking their money as emergency funds – they are relying on it as their primary source of income and lifestyle funding.
In this case the traditional defensive approach in retirement can be detrimental. Why? Because even the most stable investments carry a hidden risk – inflation. The Reserve Bank of Australia targets inflation of around 2 – 3% per year. At that rate, money’s purchasing power halves roughly every 25 years. In other words, $100 today will be worth only about $47 in 25 years if returns merely match inflation. For retirees who draw on their savings, being too conservative can mean slowly eroding real wealth, and lifestyle, over time. A retiree at age 65 may still need that capital to sustain them well into their 90s. In that context, they may share more in common with a 40 year old investor than with the traditional image of a pensioner.
A Case in Point
Consider a couple retiring at 65 with $1.2 million in super. Let’s say we apply the traditional “Defensive” approach that some funds use as a default position. The Morningstar Defensive portfolio benchmark shows that over a 10 year period the average return would have been 2.86% per annum.
Bear in mind that AFSA consider that a couple in Australia require about $75 319 per annum to maintain a “comfortable” retirement. This is once again a “once size fits all” approach that may not suit all retirees, but it provides a reasonable basis for some comparative modelling.
If we assume that lifestyle requirements increase in line with inflation, and are invested Defensively, the fund balance at life expectancy (83yrs) is $627,077, assuming that the Aged Pension kicks in as they deplete funds. Without that assistance, the fund would run out of money two years prior to life expectancy.
If that same couple takes a more long term view, and tailors a portfolio more aligned with their long term self-funded retiree requirements, they may choose to accept some volatility in exchange for longer term investment outcomes.
Let’s assume they apply the 10 year Mornignstar Balanced investor outcome of 6.50% per annum. At the same level of inflation linked income drawdown, their funds at life expectancy and with some Centrelink support will be worth $1,190,151 – almost double the funds available for family legacy purposes, or additional spending in retirement.
And if they adopt a Growth type portfolio, that end balance rises to $1,682,032 – that represents a difference of over a million dollars based on investment mix decisions.
Of course many factors need to be considered, for example, past performance isn’t an indicator of future outcomes. It’s also important to maintain adequate levels of cash reserves and manage sequencing and liquidity risks and liquidity for unexpected circumstances. All of these elements form part of the comprehensive approach taken when building tailored, fit for purpose investment portfolios.
The Bottom Line
The assumption that retirees should automatically become conservative investors is outdated and not aligned with the modern reality of the self-funded retiree and their lifestyle requirements. With longer lifespans, larger super balances, and rising costs, today’s retirees need to think less about avoiding volatility, and instead managing it, to preserve real wealth and lifestyle. Advisors and investors alike must shift from ‘defensive equals safe’ to a more nuanced understanding of risk that keeps pace with modern retirement. Of course, it is imperative that retirees take the right advice for their specific circumstances before making any decisions with their hard-earned funds.
Raymond Pecotic is the Managing Director of Empire Financial Group.
