Risk and retirement income

Is my nest egg big enough to give me the sustainable income I will want in retirement? And where should I invest it once I retire?

Throughout a person’s working life, retirement income planning revolves around the questions: How much do I need to save to live on when I am no longer relying on paid employment? And where should I invest it in the meantime?  Retirement calculators, like those provided by www.sorted.org.nz and other websites, assist with that deliberation, and financial advisers can provide detailed advice and then help with implementation of an investment strategy.

Financial decision-making for the next phase of life has received less public attention:  If I was to retire from paid work now, what sustainable level of income would my investment portfolio support?   And where should I invest it?  These are reasonable and straightforward questions to ask. However, answering them with any confidence requires sorting through a whole range of factors, including portfolio allocation, risk tolerance, inflation, super scheme rules, public pensions, taxes, insurance, home ownership, lumpy or unanticipated expenditure requirements, legacies, financial market returns and volatility, and uncertainty about your future health and longevity: A very complex calculation.

This note addresses a small, but important, part of this calculation: the implications of risk in determining a sustainable income level from a given portfolio of wealth. I use a simplified scenario to work through four levels of sophistication, starting with expected values, then successively taking account of longevity risk, financial market return volatility, and their interaction. I finally consider the implications of portfolio choice.

The key insights are:

  • Risk matters in that the sustainable annual drawing rate is lower when risk is taken into account. Planning just on the basis of expected values of investment returns and longevity is therefore not advisable.
  • However, once financial volatility and longevity risk are taken into account, a more risky financial portfolio actually may lead to a better outcome on the risk-return relationship that ultimately matters; that is, maximising the sustainable rate of annual drawings from your financial portfolio while minimising the likelihood of the portfolio being exhausted before you die. This challenges the accepted wisdom that one should move inevitably to a more conservative investment portfolio in retirement.

[Download the detailed note here.]