There are a number of investment risks facing those in or nearing retirement. In this article, we aim to bring the key risks to light.

Longevity risk

Australia has one of the highest life expectancies in the world, ranking fourth amongst OECD countries. The most recent data, published in 2022, showed that Australian men had a life expectancy of 81.3 years of age at birth, while women were expected to live four years longer to 85.4 years old¹.

These estimates are a significant increase on figures from six decades ago, and a drastic rise on the prior century. In 1900, the average Australian male had a life expectancy of 51.1 years, while females were expected to live to 54.8. By 1962, this had increased to 67.9 for males and 74.2 for females¹.

While Australians living longer is good news, there are financial considerations attached to a lengthy life. Namely, longevity risk, which is the risk that individuals will live longer than expected and outlive their savings.

The average age of those who retired in 2022 was 64.8 years.

As an example of longevity risk in action, take a woman born in 1962 who intends to retire at 65 years of age with a $1 million portfolio. Her life expectancy at birth was 74.2 years of age, meaning $1 million would only need to cover a nine-year retirement.

However, once the woman reaches retirement and turns 65, her expected age at death has increased to 80.7 years. This would mean she now must make her savings stretch 16 years. If she outlives her life expectancy at age 65 by two years, her retirement savings must last twice as long as she had originally planned for.

If she lives into her nineties, she would need to make her savings stretch 30 years or more! Alternatively, she’d need to depend on the age pension for her last, unspecified number of years of life. This would likely not cover the standard of living the woman is accustomed to. To avoid this, a common guideline is to plan for roughly 30 years of retirement and strategize withdrawals accordingly.

Inflation risk

Inflation risk refers to the potential for rising prices to erode purchasing power over time. For example, if inflation was to consistently remain at the midpoint of the Reserve Bank of Australia’s target range (2.5%), one dollar today would be worth roughly half as much in 29 years’ time.

Why is this a problem for retirement planning? Because as mentioned above, many people live for 30 years or more in retirement – long enough for the purchasing power of their savings to be significantly eroded.

To avoid having to make uncomfortable lifestyle sacrifices (or even deciding which groceries to forgo) in retirement, it is vital to seek investments with capital growth potential. This will ensure income returns are generated from an increasing capital base, thereby providing a greater opportunity to outpace inflation when compared to other investments, such as cash.

It also helps to understand the difference between nominal and real returns. Nominal returns refer to the ‘‘face’ return on an investment over a given timeframe. If a $1.00 asset increases in value by $0.05 over 12 months, and over the same period delivers $0.02 in income – its nominal return is 7% ($0.05 + $0.02 = $0.07, which is 7% of the $1.00 starting value).

If inflation over the same period is 2%, then the real return of that asset is 5% (7% – 2% = 5%) over that 12-month period. Real returns factor in inflation.

Inflation doesn’t impact all investments in the same way. Importantly, some assets that are considered ‘defensive’ can represent a poor defence against the impact of inflation.

Investment risk

Investment risk includes market risk and interest rate risk, as well as a broader range of risks associated with individual investments. This includes factors such as credit risk (the risk that a bond issuer will default), liquidity risk (the risk that an investment can’t be sold quickly without a loss), as well as specific risks related to individual companies and sectors.

Below, we touch on asset-specific risk, market risk and interest rate risk in more detail, as well as the implications of both to retirees.

Asset-specific risk

The risk associated with a single asset is known as asset-specific risk. One company can go bankrupt, sending its shares plummeting and having potentially devasting impacts on investor portfolios. One loan could go into default and fail to return capital to investors. One property could have particular features or be located in a suburb that becomes unappealing to tenants or buyers, leaving the investor stuck in a non-performing asset.

Asset-specific risk can never be eliminated. It can be reduced through thorough research and a solid asset-selection process. This is where professional management is important.

It can also be managed through diversification. A portfolio of shares in different companies will bear less of an impact of one company going bankrupt. A portfolio of loans to different borrowers will bear less of an impact to one poor performing loan. A portfolio of multiple properties will bear less of an impact to one poor performing property.

Market risk

Market risk refers to the potential for negative returns due to market-wide events. Economic, technological, political or legal conditions may impact investments, as well as general market sentiment.

There are both foreseeable and unforeseeable factors that can contribute to market risk. The natural progression of an economic cycle, which is the fluctuation of an economy between periods of expansion and contraction, is a foreseeable contributor. On the other hand, far-reaching events such as the Global Financial Crisis (GFC) and COVID-19 pandemic caused unforeseen shocks to the share market. The GFC also caused the property market to stagnate for a period of time and even impacted credit investments.

Like asset-specific risk, market-risk cannot be eliminated, but it can be reduced, and so can its impacts. Again, professional management is key – a fund manager with the resources to implement thorough research, asset selection and portfolio management processes is more likely to manage risk than an individual investor.

Diversification is also vital. Just as its important to hold multiple assets in a portfolio, holding multiple asset classes helps too. This way, if a market-wide event hits an entire asset class detrimentally, a portfolio may be buoyed by some of its other holdings.

Interest rate risk

Changes in interest rates can affect investment returns either positively or negatively. This is known as interest rate risk. Government bonds, for example, can fall in value when interest rates rise. As new bonds are issued at higher rates, existing bonds with lower rates become less attractive, causing their prices to drop.

On the other hand, in a rising rate environment, a country’s currency tends to increase in value, meaning cash may perform strongly. As a central bank raises interest rates, that country’s currency typically appreciates in value because higher rates attract foreign investors seeking better returns, who need to purchase the local currency to invest.

Interest rate risk, once again, highlights the importance of a diversified portfolio.

Sequencing risk

Sequencing risk arises from the order in which investments and withdrawals are made, as compared with when positive or adverse returns occur.

For example, taking a lump sum at retirement, particularly shortly after a negative market correction, carries the risk of being underexposed to strong returns over the ensuing few years and missing the recovery.

Similarly, holding off investing until you have a sizeable sum to invest, and then investing a lump sum, carries the risk of being overexposed to negative returns if a negative market event occurs shortly after investing.

There are a few ways to mitigate sequencing risk.

Firstly, it is again important to diversify, reducing the impact that a single adverse event in a single market can have on your overall portfolio.

Secondly, it helps to avoid large lump sum withdrawals where possible. A large lump sum withdrawal at an inopportune time could crystallise losses after a crash or forego upside during a recovery. Adopting a withdrawal strategy that you are comfortable with can also assist – whether it is a dynamic strategy based on market conditions, or relying on the popular ‘4% rule’.

Similarly, rather than hoarding money as cash before accumulating and investing a large lump sum, consider investing over time, as you earn the money. This strategy is commonly referred to as dollar cost averaging. If a negative market event occurs shortly after you commence making smaller investments, continuing to make smaller investments over time enables you to incrementally increase your market exposure to any recovery or improvement in returns. In the case of ‘growth’ assets like shares, continuing to dollar cost average after a downturn gradually reduces the average buy-in price of the assets you invest in, hence the term ‘dollar cost averaging’.

Using high yield investments can result in lower sequencing risk. This is because an investor who can afford to live purely off the yield of their investment, theoretically never needs to sell down their holdings – which means zero sequencing risk.

Finally, investing in assets with relatively stable capital values can also reduce sequencing risk. If an asset does not go up and down in value frequently, then an investor is less likely to find themselves having to sell assets shortly after a drop or buying in at a peak.

Withdrawal risk

Withdrawal risk is the prospect of withdrawing too much, too quickly, thereby putting retirees at risk of running out of money.

This scenario may arise as a result of healthcare risk, which refers to unexpected medical expenses. Additionally, care needs may also result in large, unforeseen withdrawals that can be a significant burden in retirement. It is, therefore, vital to determine a sustainable withdrawal rate.

For example, the 4% rule is an often-utilised strategy for retirement portfolios the world over. The basis of the rule is that a ‘safe’ withdrawal rate is 4% of a given retirement portfolio on an annual basis. However, this is not a ‘one size fits all’ approach, and each investor’s circumstances and needs differ.

Retirement is an exciting time, but it is vital to prepare accordingly to ensure a maintained standard of living. To learn more, download our guide, ‘Funding the three phases of retirement’.

¹ https://www.aihw.gov.au/reports/life-expectancy-deaths/deaths-in-australia/contents/life-expectancy

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