Whenever the topic of retirement is raised, one of the first questions asked is how much do I need? There’s no consensus on the right answer, but typically estimates are framed in terms of a lump sum amount at the point of retirement. There’s no doubt this provides a simple reference point to compare your current position against, but to my mind it overlooks the fundamental driver of this benchmark: the level of cash flow a lump sum amount can generate.
As an example, over the last decade official cash rates in Australia have fallen from 5.5 per cent at the beginning of the 2005 financial year to only 2 per cent in 2015. Assuming your spending had remained unchanged over this ten year period your balance would have had to have risen by a massive 275 per cent in order to deliver the same per annum cash flow. Any increases to your spending needs would have only exacerbated things. Now, I’ll admit that these cuts in the cash rate have occurred during a period of unusual macroeconomic conditions, but nevertheless it illustrates the importance of paying attention to the rate at which your pool of financial capital can be converted into a cash flow, rather than only the size of that pool.
You may have noticed that I’m talking in terms of cash flow, not income, so what’s the difference? From my perspective, income refers to the payments that you ‘naturally’ receive as an owner of a financial asset (i.e. dividends, coupons), while cash flow includes income as well as the proceeds of any sales. That’s right, you read correctly, I’m suggesting that in retirement the management of your financial assets may include capital spending. There’s no doubt that drawing on your capital increases the risk of it running out early, but I’d argue that if you’re trying to target something close to your pre-retirement lifestyle then spending too slowly could be equally as counterproductive in achieving this as spending too quickly.
Designing an investment strategy which balances these risks requires a shift in focus from the pre-retirement mindset of wealth maximisation. In this sense, assessments around individual asset risk/return profiles move away from measures of expected return and volatility towards evaluations of cash flow capacity and stability. Under this framework, assets regularly delivering a high proportion of their total returns as income would be considered more valuable. That isn’t to say you couldn’t allocate some of your capital to assets with a higher potential for capital gains, just that this allocation needs to be carefully chosen to minimise the chance of you having to realise capital losses. After all, you don’t want to be relying on a market rebound to pay the bills.
Where’s QSuper in all of this? Well, we’ve launched Money Map which is our member exclusive online dashboard to support you in keeping track of your spending requirements and forming a comprehensive picture of your financial position. In terms of our retirement offerings, we’re currently developing tools and solutions to assist you in building investment strategies that in addition to other priorities, addresses the challenge of converting capital into cash flow. So stay tuned.
The views of the author and those who provide the responses to comments posted on this blog are not necessarily the views of QSuper. This information is for general purposes only. It is not intended to constitute advice and persons should seek professional advice before relying on this information.
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