‘Bucket’ system could reduce the volatility
Bill and Lynn receive combined government pensions of $21,840 a year. They want an annual retirement income of $52,000, meaning Bill’s parttime work needs to contribute $30,160.
If Bill stops working it is likely that they would receive a combined annual pension of $34,000. They would then require $18,000 a year from their capital (representing an annual drawdown of 6%). However, a conservative portfolio is unlikely to achieve this level of return, so Bill and Lynn may need to reduce their expectations.
If they wish to preserve the capital, they would need an annual investment return of 7%-8% to also cover inflation. This means having a diversified portfolio with some allocation to growth assets, such as Australian and international equities and property. These have greater return potential but are also more volatile, so Bill and Lynn may need to take on more risk than they would have liked.
The good news is that a large part of the return on Australian equities is from dividend income, which for large Australian stocks tends to be less volatile than share prices. For instance, the ASX 200 shares index currently provides an annual dividend yield of 4.02%, which is 80% franked (tax paid) to provide a total yield of 5.4%. The franking credits received on this income represent a credit for the tax already paid, and are refunded to investors where their tax rate is below the 30% company tax rate.
A big concern for Bill and Lynn is the volatility associated with investing their savings. Strategies that could be used to minimise volatility include:
A “bucket” system where a number of years of income are locked away in cash and term deposits to ensure that payments continue uninterrupted if markets fall. For example, keeping just over $100,000 in secure assets would represent six years of income payments at $18,000 a year. If markets fall, it’s unlikely growth assets would need to be sold down to fund the $18,000 a year for at least six years, giving those assets a chance to recover.
Spreading investments across asset classes reduces the risk associated with any one asset class. For example, an exchange traded fund could be used to achieve a diversified exposure to the Australian sharemarket.
They could also consider investing some of their savings in an annuity, providing regular payments in exchange for a lump sum upfront, but this is unlikely to achieve the desired return.
If Bill and Lynn wish to target a 7%-8% return, a diversified approach should be considered. They could consider having a portfolio with an exposure to Australian and international equities to provide the opportunity for yield and capital growth, together with an allocation to secure assets, which could include an annuity to provide the guaranteed cash flow.
To achieve a return of 7%-8% they may need to take on more risk