Be alert but not alarmed

As you count down to a happy and comfortable retirement, there are many financial challenges to consider and dangers to avoid

Risks come in many shapes and sizes, and recognising them can help you protect your precious assets.

Self-inflicted or behavioural risk

These are sins of omission (things you failed to do) and sins of commission (things you chose to do, which led to bad outcomes).

There are many examples of self-inflicted risk. I hope that knowing about them can save you from making similar mistakes. A classic self-inflicted risk is putting all your money into one investment, particularly if you do so without looking into it carefully – like the man who invested his life savings of $660,000 in a company purely on the grounds of its enticing newspaper advertisements and lost the lot.

It can also be that you draw down too quickly on your capital, reducing its ability to last as long as you do. When I was in private practice as a financial planner we

commonly heard of situations where retirees drew aggressively on their capital to help their children out of a problem, and so put their own assets at serious risk.

EXAMPLE I received an email from a man who told me that he and his wife had gone tenants-in-common with their daughter, on a 75:25 basis 30 years ago, to help her buy her first home for $80,000. For 30 years she has paid all expenses in relation to that house. The parents are now faced with a double whammy: the house is worth $600,000, which means their 75% share is worth $450,000. They are on a minuscule age pension, which would be $35,000 a year more if the house was in just their daughter’s name. But if they transferred it to her now, they would be liable for a large sum in capital gains tax, and still have to wait out the required five years before the asset vanished from Centrelink’s records.

Self-inflicted risk includes choosing to live too frugally and dying with far more money in your superannuation than you ever intended. At the other extreme, it includes investing overly conservatively, so that your money won’t generate the returns you need to achieve your goals.

Opportunity risk

This means that you make a choice, and in hindsight discover that a different choice would have given you a better outcome. For example, when the GFC hit in 2008, a friend with a self-managed superannuation fund switched the entire fund to cash to prevent any further downturns. The problem is that he has never found the right time since that date to switch any of that cash back to growth assets, and as result has missed out on all the growth that happened in markets everywhere in the past 12 years.

Or what about someone who has understood that the way to make money in real estate is to get a property at a bargain price and add value to it? They buy a rundown house in a good area for $400,000. Another person gets suckered into buying an apartment for the same price. After five years and a minor renovation the house could be worth $650,000, and the apartment would be worth $390,000 at best.

It is difficult to eliminate opportunity risk, as capital gain cannot be guaranteed. Thorough research before making the commitment helps to prevent the problem, and ongoing monitoring of the performance may help you to say “enough” after a decent period and act to withdraw your funds and look for greener pastures. A good tip is to write down the reasons for buying each asset at the time you do it. This may help you later when you are trying to decide to retain or sell.

Non-diversification risk

Reams have been written about the need to diversify – not to put all your eggs in one basket – but many investors who think they have diversified end up with no real diversification: all they have is a lot of similar baskets. This applies to people whose entire investment portfolio consists of suburban rental houses, or who are entirely invested in bank shares, or who have only cash-type deposits, even if they are with four banks. It is also common to see poorly skilled investment advisers spread a client’s money over four equity trusts that have precisely the same approach to investment. This is not meaningful diversification.

The only true diversification is to spread your assets among various classes of investments, as well as among various markets. This is why it is vital that investors in managed funds clearly understand the nature of the underlying assets that make up the portfolio.

Longevity risk

This is the risk that your lifespan will significantly exceed your life expectancy. You may think that’s a fantastic thing if you are ageing well, but it does bring up the possibility that you may outlive your money. You can mitigate this by having an appropriate asset mix, spending rationally, and having annual reviews with your adviser. There are many studies showing that more than 50% of older people underestimate their life expectancy, usually by about seven years. Fortunately, there are products that are being developed now to meet this challenge.

Life event risk

This means an unexpected change in circumstances that could have an adverse effect on your financial situation. These could include a financial collapse, such as the GFC in 2008 or the Covid-19 pandemic in 2020. It could also mean the death of a spouse, child or parent, a serious change in a family member’s health, or an unexpected need for money for one of your children.

The way to mitigate this type of risk is to keep a good buffer of capital and be flexible in your investments. For example, a lifetime annuity is very inflexible whereas an account-based pension is highly flexible – you can withdraw as much as you wish on demand. However, account-based pensions have other risks, such as market risk and legislative risk.

It’s a good policy to make sure your children have adequate life insurance, income replacement insurance and trauma insurance. If they don’t, you may find them looking to tap into your funds if they have a financial or medical setback.

Legislative risk

Governments are continually changing the rules, and today’s perfect financial plan may be obsolete on budget night. Luckily our government seems to have learnt its lesson about the folly of retrospective legislation, which is why we now have such a range of confusing transitional measures.

In the retirement space, legislative changes could include increased taxes on earnings or withdrawals from superannuation, restricted access to lump sums, changes to the balance or contribution caps, and tightening of the age pension. In 2017, for example, the pension rules were considerably tightened, and in 2019 Labor proposed a policy to eliminate refunds of franking credits.

About the only way to guard against legislative risk is to stay as flexible as possible, seek expert advice about your affairs, and monitor your investments regularly. This applies particularly in the areas of superannuation and age pensions. It is a good idea to join a group such as the Association of Independent Retirees or National Seniors Australia. They are always right across any potential changes and do a great job of keeping members fully informed.

Market risk

This relates to a situation in which you have bought an asset and its value drops. The asset may be anything from a bar of gold to shares in BHP; the nature of it makes it subject to the ebb and flow of market forces.

You protect yourself against market risk by first recognising that any asset that has the potential to rise in value may also fall in value. Once you appreciate this, you should know not to put all your funds into one asset class, or to invest in growth investments when the time frame is short. The catch 22 is that while investments like shares and property have the potential to suffer falls in value, these asset classes have historically shown the best returns over the medium to long term. This is what “risk versus reward” means. If the best returns were available in bank term deposits, there would be no point in taking a higher risk by going into property or shares.

The major danger in investing in share trusts and good property and is that you will be forced by circumstances to sell the assets when the market is depressed. This must be avoided, which is simple to do by keeping sufficient money in cash assets for your foreseeable requirements.

When Covid-19 struck, many retirees copped a double whammy: their share portfolios plunged and then three of the major banks announced there would be no dividend payments for the next six months. Those who did not have three years’ expenses in cash – instead relying on the combination of their dividends and franking credits for current spending – were caught out.

Market risk is one of the easiest risks to handle – if your money is with a good superannuation fund or being handled by a good adviser, you should not be at risk of losing it over the long term if you can stay invested during the inevitable downturns.

Credit risk

Credit risk is the chance that the institution you invest in will not pay it back. This may be caused by many things, including dishonesty, bad management or one or more of their borrowers have defaulted and the underlying value of the security is insufficient to discharge the debt.

Leading examples of losses because of credit risk are Gold Coast–based MFS Group, which collapsed in 2008 owing $2.5 billion, and Wattle, which scammed investors of at least $130 billion in the late 1990s. There’s also the Virgin bond issue, which fell from $100 at issue in 2018 to $14.50 in April 2020, when Virgin went unexpectedly into administration as the pandemic gutted the aviation industry.

The cure for credit risk is to use substantial corporations that have been recommended, in writing, by your investment adviser and to spread your money

between different companies so that if one does get into trouble it doesn’t take all your money with it. I am amazed how often the media feature people who have lost their life savings by investing them with just one institution.

By asking your adviser to put all recommendations in writing, you put yourself in a position to take legal action if you lose money in a “very safe” investment.

Be extremely wary of any investments advertised in the newspaper.

The major problem with investing in products such as MFS, Wattle and even Virgin is that you will probably lose all your money if they go bad. In contrast, if you invest money in an index fund or a good managed fund, their spread of assets makes it more likely that its value will recover after a fall.

Re-investment risk

I have a friend who is a big fan of the biotechnology company CSL. She invested $100,000 in it shares at $10 each in 2006 and saw them rise to $316 a share by January 2020. Her big decision was whether to stay with them or take some profits. It was no easy decision, but I did point out to her that if she sold a small portion, she could probably wipe out any capital gains tax with a personal deductible contribution to her superannuation.

Let’s assume she did sell $100,000 worth to get her original stake back – the balance would then be riding for free. She is then faced with re-investment risk: the risk of not being able to replace a very good investment with one that is as good. There is no easy answer. But anybody who is considering selling a share or a property just because they have a good profit should keep in mind that re-investment risk is a real issue, and needs to be considered.