How To Outlive Your Nest Egg

When considering saving and investments, there are several ‘hidden risks’ which are severely under-discussed (and under-estimated). People with cash in the bank may be comforted by the safety of their savings. However, while their capital may be safe their financial future is anything but. Here we look at the effects of these ‘hidden risks’, and discuss strategies to reduce these risks to a long and happy retirement.

The ‘hidden risks’ connected with retirement

Over time, inflation will erode the spending power of cash in the bank. It is very unlikely that interest rates will maintain pace with inflation, with the result that real interest rates (interest rates on savings – inflation) will be negative. Put simply, $1,000 won’t buy tomorrow what it will today.

However, the effect of inflation is not the only risk associated with a retiree’s nest egg. There are three other distinct risks which need to be considered when planning for retirement:

Longevity risk: the number of years that people are living after retiring is lengthening, necessitating the nest egg to go that little bit further.

Emotional risk is the risk a person is willing to accept to their capital when investing. This naturally diminishes with age, as there is less time to claw back any losses.

Finally, timing risk is associated with sudden falls in the investment markets near, at, or during retirement.

A well-designed financial plan is essential to providing financially secure retirement, and as part of this plan a number of strategies should be employed to mitigate identified risks.

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Retirement risk reduction strategies

Clearly, with regard to inflation, risk a person saving for retirement needs to accept some risk to their capital in order to have the potential for longer term growth. This is achieved through a sound investment strategy.

The risk of a market move against the investor is real. However, it is extremely rare that all asset classes – stocks, bonds, property, commodities – rise and fall at the same rate and at the same time. A diversified portfolio offers the best level of ‘insurance’ against this market risk.

Market timing and longevity risks can be mitigated by using capital guaranteed products, designed to provide growth in the good times and safety of capital through the bad.

Appropriate levels of investment risk

When building a portfolio for long-term growth, there are three levels of risk to capital (above the ‘risk free’ status of cash in the bank):

• Fluctuation risk

This is the shorter-term risk of adverse market movements. Markets tend to rise and fall, but historic long term averages indicate that such short term falls will be regained over the longer term.

• Capital risk

This is the risk that, when investing for extra growth, the investment will not recover its starting levels after a period of time. Maximum potential returns are only achieved by accepting higher potential risk (the risk of losing all capital invested).

• Highest risk

While many might believe that losing 100% of invested capital is the maximum loss possible, in modern markets investors are able to use various investment tools – such as margin investing – to leverage their investments. Essentially this is borrowing money to invest, and can lead to losses far larger than anticipated. This was a feature of the 2008 market decline, and more recently margin investing has seen several currency hedge funds and brokers in financial difficulties after the Swiss Central Bank removed its peg to other currencies.

Asset classes explained

When considering investing across asset classes, it is necessary to understand the risks of each and the benefits of diversification.

Cash in the bank is considered risk free (except, of course for the associated inflation risk), but some investors also mistake bonds and fixed interest investments as being risk free. Bonds are, however, market instruments whose price can fluctuate in exactly the same way as share prices might. They can also be bought and sold in the same manner.

The main difference between bonds and shares is that bonds pay a guaranteed amount of interest during their life, whereas companies (shares) are not obliged to pay any income (dividends).

When investing in shares, it is worth noting that the larger companies have a larger impact on the level of the Australian stock market. Rather than invest in a small number of companies, which may move contrary to the general stock market, diversification is often best achieved by investing in a fund that holds a range of shares. This principal also holds true when investing in fixed income instruments.

By maintaining a diversified portfolio with exposure to asset classes rather than single investment instruments, an investor mitigates risks associated with a polarised portfolio: single stocks and bonds can and do move counter to general market trends.

Become financially astute to become financially secure

To read more about the factors to be considered when designing a financial plan for retirement, click here for our free special reports which cover topics such as:

• Calculation of super needs
• Tax free living in retirement
• Risks of SMSF investment
• And more

The financially astute will look forward to a brighter, and earlier, retirement.

Get Our Full Report: Reducing The Risks Of Inflation and Outliving Your Nest Egg?

Or book a free Strategy Session through the form on the right and you’ll get access to our Successful Retirement series “Can You Really Afford to Retire?”