building a better retirement nest egg

PERSPECTIVES insights.ideas.results. 1514 PERSPECTIVES

IN SUMMARY > While energy prices have recovered a few times over the past year, they remain below what producers need to drill profitable wells.

> The decline in oil prices has significantly dampened investor sentiment about oil-exporting emerging market economies, and could lead to substantial volatility in financial markets as was observed in a number of countries during the last quarter of 2014.

> However, declining oil prices also present a significant window of opportunity to reinvigorate reforms and diversify oil-reliant economies.

> Over the medium-term, oil prices are projected to recover from their current lows, but are expected to remain below recent peaks and witness considerable bouts of volatility. The pace of the recovery in prices is likely to depend on the speed at which supply will adjust to weaker demand conditions.

> US shale oil producers, with their relatively short production cycles and low sunk costs, may see the greatest adjustments in the short-term.

> Over the longer term, adjustment will take place from both conventional and unconventional sources through cancellation of projects.

> While supply is likely to be truncated, ongoing demand will be underpinned by recovering global activity in line with broader demographic trends.

JEFF ROGERS CIO iPac and Head of Investment Solutions Multi-Asset Group

CONTRIBUTING AUTHORS

STEPHEN FLEGG Portfolio Manager Multi-Asset Group

INSIGHTS.IDEAS.RESULTS.

‘The question isn't at what age I want to retire, it's at what income.’

- George Foreman

BUILDING A BETTER RETIREMENT NEST EGG

In 1970, the average person in the OECD spent two years in retirement; by 2012 this had increased to 15 years. Many workers in the developed world now spend as much of their life out of the workforce as they do in. Given this seismic change, saving enough for retirement is a pressing global issue for individuals as well as policy makers.

KEY POINTSOur analysis suggests that the amount an individual contributes to their savings and the rate-of-return on their investment contributes similarly to the size of their savings at retirement. However, there are a number of additional dynamics at play that can affect the absolute size of the retirement nest egg:

> The sequencing of savings contributions

> The tax treatment of savings and investment returns

> The asset allocation of their investment strategy

> The sequence of investment returns


In Australia, as people live longer than ever before there has been a marked increase in the number of people who are delaying

retirement to the age of 70 or beyond, partly reflecting changes to the qualification age for

the age pension. A recent report from the Australian Bureau of Statistics (ABS) on

retirement and retirement intentions observed that 47% of people

already retired are dependent on a government pension or

allowance as their main source of income. The corresponding

increase in the burden on public finances, and

subsequent moderation of government spending on the age pension, has made increasing the size of private retirement savings a key priority for both the government and individuals approaching retirement.This paper examines the factors that influence the size of a person’s retirement nest egg by analysing the experience of Australian workers during the past 25 years

since the modern compulsory superannuation system was

adopted. The paper also outlines a number of ways current workers

can contribute to increasing the size of their retirement savings and

enjoy a higher income after leaving the workforce.

SAVING FOR RETIREMENT: WHAT MATTERS MOST?Our analysis of the factors driving the size of the savings balances at retirement is based on a standard worker who works fulltime from age 20 and receives average earnings that grow at the historic wage growth rate of 3.5% per annum (p.a.) as measured by the ABS. We also assume that the worker invests in a traditional balanced fund, which is proxied by the average of the Morningstar Growth Category.

Contributions versus investment returns

Based on the experience of Australians during the past 25 years, the size of a worker’s savings at retirement is overwhelming dictated by two things: how much they contribute and the rate of return on their investment.

For the average worker, approximately 60% of their retirement nest egg is attributable to investment returns, with the other 40% directly attributed to their contributions to savings. Analysis of investment returns shows that the vast majority (more than 90%) of returns are associated with the asset allocation (risk profile) chosen by the worker with only a small percentage attributable to active management.

Figure 1: Retirement savings – where do they come from?

Source: Morningstar, AMP Capital

GOALS-BASED PERSPECTIVES: RETIREMENT GOALS INFORM PRE-RETIREE STRATEGIESBuilding a sufficient retirement nest-egg is in itself an intermediate goal. The ultimate purpose of the nest egg is to fund a person’s lifestyle in retirement.

While it makes sense for young accumulators to concentrate their asset strategy on building wealth for the future, it is appropriate that older workers also focus their strategy on the timing and priority of spending goals in retirement. These spending intentions should influence investment strategy in the lead up to retirement and post-retirement.

For instance, if the intention is to withdraw a lump sum at retirement to pay out the residual mortgage on the family home, then it makes sense to progressively de-risk the strategy on that portion of the capital required to meet this goal. Alternatively, some retirees may wish to allocate capital to fund future bequests to support family members or charities. The time horizon associated with these goals is likely to be long term, which argues for a re-risking of the capital funding these goals.

For most retirees, however, the bulk of their nest egg will be assigned to fund essential and lifestyle goals in retirement. In this case, a relatively seamless continuation of the multi-asset strategy designed for pre-retirement (that accounts for any change in tax status) may be appropriate to carry into a post-retirement investment strategy. In the early years of retirement, a retiree should allow some flexibility to adjust some of their discretionary spending in response to portfolio outcomes. This will help ensure that cash flows are sustainable over the long term.

Given the diversity of spending intentions post-retirement, this article has a focus on pre-retirement accumulation with a particular emphasis on young and middle-aged workers. As accumulators approach retirement, their investment strategy should become more nuanced and tailored to address specific spending intentions and goals.

Contributions 41%

Investment Returns (Asset Allocation) 51%

Investment Returns (Active Management) 2%


SEQUENCE OF CONTRIBUTIONS: THE IMPORTANCE OF EARLY TAX-EFFECTIVE CONTRIBUTIONSNot all contributions are equal when it comes to saving for retirement. We have used the experience of a standard Australian worker invested in a traditional balanced fund during the past 25 years, receiving annualised return of 6.5% p.a., as a guide. Due to the compounding of returns, each dollar contributed into savings at age 20 grows in real terms to be worth just over $6 at retirement.

It is important to note, however, that the magnitude of this compounding is greatly affected by tax treatment of returns. For the same individual with the same returns, subject to a 30% tax rate, a dollar saved at age 20 only grows to be worth $2.60 in real terms at retirement. Compounding returns over time disproportionately benefits individuals who contribute to their retirement savings early in their careers and utilise tax effective saving vehicles. The exponential nature of this relationship is illustrated in figure 2.

It is important to note that while young people will benefit the most from utilising a tax-effective savings vehicle, this gain needs to be considered against the cost of losing access to savings for a longer period of time.

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Source: AMP Capital.

Making contributions to retirement savings early in a career is important. Individuals who take long periods of time away from the workforce early in their career have significantly less at retirement then those who remain employed. Figure 3 depicts the expected shortfall in retirement savings versus a full-time worker with no career breaks at differing ages. A person who leaves the workforce for a decade at age 25 is forecast to retire with almost 30% less than a worker who remains in the workforce. However, if the same period of absence from work had begun at age 50, the relative shortfall would be roughly half as much at approximately 15%. People who take time out of the workforce early in their careers, perhaps owing to family commitments, to travel or to pursue studies, are expected to have retirement savings significantly lower than peers who stay employed. Catching up with these peers is difficult as they not only need to make up for the early contributions they missed out on, they also need to make additional contributions to make up for the compounding tax-advantaged investment returns that their peers received.

Figure 3: Shortfall in retirement balance from a 10-year absence from work (relative to a fulltime employee) at different ages


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INVESTMENT RETURNS: THE IMPORTANCE OF ASSET ALLOCATIONGiven that approximately 60% of retirement savings are attributable to investment returns, it’s important to understand what’s driving that return. Our analysis indicates that the most significant factor affecting the magnitude of returns is the asset allocation/risk profile of the investments.

The experience in Australia highlights that investors with a higher tolerance for risk, that is greater exposure to growth assets, enjoy higher returns over the long term (as depicted in figure 4). Since 1990, the average growth investor has received cumulative net investment returns that are approximately 63% higher than investors who kept their savings in cash.

Figure 4: Cumulative returns over time for differing risk profiles*

Source: Morningstar multi-sector category averages, AMP Capital. Benchmark indices: Morningstar Aus Msec Growth TR AUD; Morningstar Aus Msec Balanced TR AUD; Morningstar Aus Msec Conservative TR AUD; RBA Bank accepted Bills 90 Days. These returns assume distributions are reinvested. Past performance is not a reliable indicator of future performance. Returns for periods greater than a year are annualised. Net performance is calculated after fees, expenses and taxes.

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Although the majority of returns for risk-based investors are attributable to asset allocation, active management can still play an important role in improving retirement balances:

> Our analysis of fund returns in the Morningstar database (post fees) indicates that active managers contribute more value than their fees detract

> Any value that managers can contribute in excess of their fees results in more money at retirement for investors. If a manager can add 0.5% of value a year, as suggested by figure 6, an average investor’s savings at retirement will be 15% larger. In dollar terms, this equates to an additional $150,000 to $200,000 at retirement

Figure 6: Source of cumulative returns**

Our analysis of the source of returns during the last decade reveals that 97% of all returns for a growth investor are driven by asset allocation. On average, 3% can be attributed to active management, although we have found good active management still has a long-lasting, positive impact on balances. We observe similar results across the various risk profiles* as depicted in figure 5.

Figure 5: Sources of investment returns over the past 10-years

Source: Morningstar multi-sector fund category averages, AMP Capital. Benchmark indices: Morningstar Aus Msec Conservative TR; Morningstar Aus Msec Balanced TR AUD; Morningstar Aus Msec Growth TR AUD; Morningstar Aus Msec Aggressive TR AUD. These returns assume distributions are reinvested. Past performance is not a reliable indicator of future performance. Returns for periods greater than a year are annualised. Net performance is calculated after fees, expenses and taxes.

** Multi-sector growth fund averageSource: Morningstar, AMP Capital. These returns assume distributions are reinvested. Past performance is not a reliable indicator of future performance. Returns for periods greater than a year are annualised. Net performance is calculated after fees, expenses and taxes.


As we have observed, not all dollars contributed to savings are equal; similarly, not all returns or risk are equal either. Younger savers have the advantage of having time on their side. Younger savers are affected less by drawdowns because they have time for investment conditions to recover and they still have future contributions to make that aren’t impacted by the drawdown.

As depicted in figure 9, an investor who suffers a 25% loss of capital at capital at age 30 is expected to have a 0.8% reduction in their retirement balance as a result. Even at age 50, a 25% drawdown is only expected to have a 7% impact on a savers balance at retirement. At age 60, the impact has exponentially increased to 17%.

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Due to the advantage of having time, young investors are relatively immune to the negative effects of market corrections. Conversely they also benefit much more from compounding returns than older savers. High returns for younger investors help build a larger pool of savings, which then compound at higher rates. Younger investors also don’t have immediate access to their savings so are also less likely to exhibit counterproductive behavioural biases such as impulsively reacting to market weakness by withdrawing their money from the market.

Young investors have a high capacity to bear volatility, have a long investment horizon (which is often enforced by regulations that prohibit access to their savings) and receive disproportionate benefits from returns. Consequently, younger investors benefit substantially from pursuing a more aggressive asset allocation than older savers.

Figure 7: Proportion of retirement balance directly attributable to contributions


Figure 8: Impact of an increase in retirement savings at retirement (relative to 0%)


Figure 9: Percentage reduction of retirement balance due to a 25% drawdown at different ages


SEQUENCE OF RETURNS: A REAL RISK FOR PRE-RETIREES

a) The importance of early returns and late risk management

Our analysis suggests that individuals can increase the proportion of their retirement savings attributable to returns by choosing both an appropriate asset allocation and good active managers. We estimate that if a person can increase the real return they earn from 3.5% to 4.5% p.a. on their savings, they will have a nest egg at retirement that is not only 31% larger, it is also 70% attributable to investment returns versus 60% at the lower real return rate.

To put this into context, an individual who chose an aggressive risk profile (more than90% growth assets) since 1990 received investment returns that were 2.7% p.a. higher and would have retired with a balance 300% larger than a risk-averse investor who chose cash. In selecting an appropriate asset allocation and a good active manager, individuals can reduce the reliance of their retirement savings from direct contributions. The reliance of retirement incomes from direct contributions is further reduced if workers continue to stay appropriately invested after reaching retirement.

Figure 7 depicts how the reliance on contributions versus returns falls as the level of returns increase. At higher levels of real returns, an individual’s reliance on contributions to drive the retirement balance is reduced.

Investment returns contribute a large portion of the retirement savings for workers and, due to compounding, an increase in returns has an exponential effect on the size of balances at retirement. This is shown in figure 8. The experience of the standard Australian worker shows that the investors who fared best over time were those who:

1. Stayed invested in the market. All investment categories (conservative through to aggressive) delivered significantly better returns than just staying in cash.

2. Invested in growth strategies early in their career and utilised compounding of these higher returns to build their balances

3. Selected an appropriate active manager. An improvement in returns of as little as 0.1% a year has a significant impact the retirement balance once compounded over a working life

This analysis also suggests that having the right investment strategy is particularly important for workers who are unable to easily increase their contributions. By improving investment returns, through an appropriate asset allocation strategy and active management, the size of the total retirement nest egg is less reliant on contributions


The probability of loss sharply declines over time for growth assets such as equities.

Higher risk profile asset allocations benefit from more reliable outperformance over longer time horizons.

Figure 10: Historical probability of Australian shares delivering a negative return and less than CPI +3%

Source: AMP Capital, Bloomberg, as at 30 June 2016, MSCI Australia Accumulation Index in AUD. Past performance is not a reliable indicator of future performance.

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b) The importance of the investment horizon

Many aspects of investing only hold true during the long term. If you were to look at a short time horizon, say a day, shares don’t reliably outperform conservative investments such as cash. However, over longer time horizons riskier investments consistently outperform more conservative assets. For instance, on a daily basis, shares deliver a positive return 53% of the time. Over a longer six-year investment horizon, however, the S&P/ASX All Ordinaries Total Return Index since inception has delivered a positive return 99% of the time for Australian share investors. Similarly, there is no 10-year period on record where the S&P/ASX All Ordinaries Total Return Index underperformed CPI+3%.

Historically, after dividends are captured in returns, the probability of loss for equities sharply declines over time, as depicted in figure 10. This dynamic has been coined ‘time diversification’ because over longer time periods, investors will experience a variety of different market conditions.

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investment horizon, however, the S&P/ASX All

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positive return 99% of the time for Australian share investors. Similarly,

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CPI+3%.

Comparing the performance of different risk profiles paints a similar picture. Figure 11 depicts a mix of risk profiles and time by capturing the outperformance of high risk funds relative to low risk funds over given time periods. Over short time periods, such as a month, funds with a higher allocation to growth assets outperform 60% of the time. Over a five-year time horizon, higher risk funds outperform 75% of the time. In order to reliably get a benefit from moving out into higher risk profiles, investors must have a long investment horizon, which (at a minimum) is greater than five years,

Figure 11: Funds with a higher allocation to growth assets are more likely to outperform over the long term

Source: AMP Capital. For illustrative purposes only.

Investors who have long investment horizons can typically rely on the risk premiums of different asset class to consistently deliver performance. They also are less sensitive to an enduring drawdown due to the benefits of time diversification. For periods less than five years, however, investors shouldn’t rely on a typical diversified fund to deliver the performance they expect and could consider alternative multi-asset styles of investing, which focus on protecting against drawdowns.


IN SUMMARY > The experience of Australian workers since the introduction of mandatory superannuation in the early 1990s highlights that both contribution rates and investment returns play an important role in saving for retirement.

> In addition to maximising the amount of contributions an individual makes, individuals can significantly increase the size of their nest egg by contributing to their savings early in their career and by utilising tax-effective saving vehicles.

> The major determinant of investment returns during an individual’s working life is asset allocation.

> Active management represents a smaller proportion of the final retirement outcome but can make a significant difference to the total dollar balance at retirement.

> The sequencing of returns has a large impact on the size of retirement balances. Young workers who have time on their side and relatively small balances should seek to maximise returns by choosing more aggressive risk profiles early in their working life. Younger workers can rely on the risk premiums of growth assets to deliver excess returns over the long term, and also benefit from those excess returns compounding.

> Older workers, who are more vulnerable to market drawdowns due to their larger balances, short investment horizon and fewer future contributions, should be more aware of risk management. They could consider non-traditional multi-asset solution to protect against drawdowns.

1 Retirement and retirement intentions, Australia, July 2014 to June 2015, Australian Bureau of Statistics, Cat No: 6238.0

JEFF ROGERS CIO iPac and Head of Investment Solutions Multi-Asset Group

CONTRIBUTING AUTHORS

STEPHEN FLEGG Portfolio Manager Multi-Asset Group

INSIGHTS.IDEAS.RESULTS.

“There are two main drivers of asset class returns - inflation and growth.” – Ray Dalio, CIO and founder of the investment firm Bridgewater Associates, excerpt from the Council on Foreign Relations, September 12, 2012

THERE’S NO ESCAPING A LACKLUSTRE RETURN POTENTIAL

In this paper, we discuss the medium-term return potential from major assets and the implications for investors.

KEY POINTS > Low and falling investment yields from most major asset classes point to a constrained medium-term return outlook.

> For a diversified mix of assets, the medium-term return potential is around 6.9% on our projections.

> In the current environment of low inflation, the key for investors is to have realistic return expectations, focus on asset allocation and consider assets that offer sustainable income.

building a better retirement nest egg

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