The three pot approach
I LAMENT the demise of the defined benefit superannuation scheme. On retirement, members of these schemes got a certain amount of income for the rest of their lives: say, 60 per cent of the finishing salary. After they died, their spouses carried on getting at least a part of the income until their own death. With both deceased, the income stopped: although there was nothing left to go into the estate, super scheme members had gone into retirement knowing exactly the amount of income that they had to spend and were not at the mercy of financial markets.
There are still a few of these old generous schemes left. They are closed to new members (regrettably) but there are still a good number of people in (or close to) retirement who are the beneficiaries of such certainty. Mostly the remaining members are long-standing government employees who resisted the temptation to convert to some kind of lump sum scheme back in the 1990s.
Around the world, employer superannuation providers have been closing down defined benefit schemes as fast as they can, and putting the investment risk back on the superannuitant. The liability to provide an income for life is so great that it put plenty of companies in trouble. This was caused mostly by ever-increasing longevity and, since the GFC, low interest rates making it ever more difficult for the superannuation providers to meet their pension liabilities. Employers everywhere want to shift this liability to provide income from uncertain investment markets off to someone else.
And so now we have defined contributions schemes whereby instead of getting an income on retirement, our savings give a lump sum and we are left to our own devices to invest it. I have long thought that investing a lump sum for income is the hardest thing to do in all of finance.
It is difficult because retirees have three competing liabilities (or risks) that they have to meet: first, they need a nice steady and reliable income. Second, they need liquidity to meet their immediate needs and to cope with the unexpected. Third, they have to contend with inflation – a dollar of income today will not be the same in 10 years or more.
These three liabilities are often in conflict with each other and, most importantly, there is no single investment type that can meet all of them: it is no easy matter to invest for income, liquidity and manage inflation all at the same time.
The solution is to divvy up your investment capital into three different pots each with assets to match one of the three different liabilities that you have. The first pot is for income and this is likely to require around half of your available capital. It will mostly contain bonds and other investments that will give you predictable income. The important thing for this pot is that there is minimal income volatility – you should know exactly the amount of income that you are likely to receive in the coming few years. Overseas investors would add variable annuities to this pot. These are not yet available in this country but as I outlined in this column in April, there is a company that is working on them here.
The second pot is for liquidity and this is simply a cash reserve. For a retired person such a reserve might make up 10 per cent of the portfolio and needs to be available for emergency to cover any financial shock or unexpected expenditure that you might have.
The third pot is for inflation and will be at least 20 per cent of the portfolio and perhaps as much as 40 per cent. This pot will be made up of shares and property; things which give higher returns and which, over time, keep up with inflation. The shares and Listed Property Vehicles that make up this part of the portfolio will also give some income from dividends, but its real purpose is to keep the value of the portfolio up with inflation.
Maximising income in retirement while covering risk is no easy matter. Defined benefit schemes are not going to make a comeback: no employer is going to revert to taking on investment and longevity risk, and so we are going to have to manage this investing ourselves. A pot of investments to cover each of your major risks is a good way to think of investing in retirement. Martin Hawes is an Authorised Financial Adviser and a disclosure statement is available on request and free of charge, or can be found at martinhawes.com. This article is of a general nature and is not personalised financial advice.