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Planning for retirement can be a scary thought, whether it is just around the corner or years in the future. Martin Hawes, one of New Zealand's best-known experts on personal financial answers all of the questions that may be keeping you up at night: How much will I need to retire? Can I ever afford to stop working? How do I make sure my money lasts as long as I do? Working out how you can achieve a regular monthly retirement income is more difficult than it used to be. Historically low interest rates (despite the current blip) plus longer life expectancy means the old method of parking your nest egg in a savings account and living off the interest is no longer an option. Hawes guides you step-by-step through the planning process, showing you how you can safely create a regular income for the rest of your life. Cracking Open the Nest Egg will help you to confidently take control of your financial future and achieve the kind of retirement you always dreamed of.
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MARTIN HAWES
Cracking open
the nest egg
A catalogue record for this book is available from the National Library of New Zealand
ISBN 978-1-990003-46-2ISBN 978-1-990003-55-4 (ePub)ISBN 978-1-990003-56-1 (Mobi)
An Upstart Press Book
Published in 2021 by Upstart Press Ltd
26 Greenpark Road, Penrose
Auckland 1061
New Zealand
Text © Martin Hawes 2021
The moral right of the author has been asserted.
Design and format © Upstart Press Ltd 2021
All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher.
Designed by Nick Turzynski, redinc. book design, www.redinc.co.nz
Printed by Everbest Printing Co. Ltd, China
The views and opinions expressed in this book are for informational purposes only, and do not constitute personalised financial advice. Before making any financial decisions, you should consult a financial advice provider. Disclosure information relating to Martin Hawes as a Financial Advice Provider can be viewed at www.martinhawes.com.
Contents
Preface: The $7.6m problem
Introduction
Section 1 — Planning for your best retirement
Chapter 1: What’s the Plan?
Chapter 2: Spending in Retirement
Chapter 3: Making your Money Last as Long as you do
Chapter 4: Your Drawdown Rate
Chapter 5: Other Sources of Income
Chapter 6: The House
Section 2 — How to Invest in Retirement
Chapter 7: The Science of Investing in Retirement
Chapter 8: Asset Classes and Risk Management
Chapter 9: Investing and Getting Help
Afterword
Glossary
Index
Preface: The $7.6 million problem
My clients had sold the farm. The morning after settlement they got up and looked at their bank account; the balance was $7,595,777.43. Now, you might think that such a bank account balance would occasion great joy, an opportunity to drink Champagne for breakfast and to head to the mall or a travel agent.
In fact, my clients felt no joy at all — their primary emotions were fear and worry. They were looking at a very big number and this number represented everything they had. The result of their life’s work was represented by that number on the screen — and they felt vulnerable.
To a couple who had worked hard on just one thing throughout their lives, the big number did not seem real: they had swapped a very real farm for a flickering electronic signal with a number many times larger than they had ever seen before. They knew they had to do something with this large, literally unbelievable number. They knew they could not leave it with the bank: not only was it paying a pathetic amount of interest, but they wondered whether the bank was safe.
What were they going to do with this money? How could they keep it safe? How could they get an income from it? How long would it last? With all the investment options (and all the different, competing advice they were getting from neighbours, friends and family) they knew they had exchanged a bunch of farming problems, which they knew about, for a whole bunch of new problems they knew nothing about.
Even worse was the growing realisation that there was nothing they could do with this money that was perfectly safe. Shares were scary, rental property was a lot of work (and very reliant on keeping tenants) and they did not understand bonds. Even banks could occasionally go broke.
They met with a couple of financial advisers from the city but they both seemed to speak a different language and, anyway, they seemed to care more about what they knew and what they could do rather than what a couple of newly rich farmers wanted to do with their lives.
Selling the farm and moving into town had seemed such a good idea a few months ago. Now they thought it would be much easier to worry about drought, wool prices and fence repairs than their brand new $7,595,777.43 problem.
This is an extreme example of what is happening around the country at the moment. Certainly, the number is bigger than usual, and most of us would think that $7,595,777.43 is not a bad problem to have! However, extreme though this example is (and it is nearly a true story), there are many people of retirement age who are looking at their nest egg — they’ve come into some cash (whether from downsizing the house, cashing in KiwiSaver, receiving an inheritance, or selling the business) and are now dealing with the biggest amount of cash they have seen in their lives, and ever will see — and they know there is not another egg in the nest!
This is all the money you are ever going to have — you have to use it well because, if you mess it up, you are not going to go back and spend another 40 years to hatch another.
$7,595,777.43 is a large number but you could take away one or two 0s and you still get left with the same set of problems. What do you do with the money you have planned to give you the retirement you want? How do you take an income? How long will the money last?
After all, you have spent years sitting on your nest egg, caring for it, and hoping that it will grow. However, there comes a time when all care is put aside, and you have to take a hammer to it and crack it open.
A tsunami of baby boomers
That wave of baby boomers is now cresting and breaking into retirement. Long predicted, this tsunami is now with us and is rolling up a beach seemingly bare of investment options. In fact, the baby boomers, who still complain about paying 20+ percent on their mortgages in the 1980s, now find themselves trying to fashion a living from their savings at exactly the time interest rates are at record lows. At the same time as interest rates are low, we have very highly priced shares and property with poor dividend and rental yields.
We have a problem: baby boomers were always told they needed to save for retirement. By and large they did this, and many have now got to retirement age with nest eggs of varying size (yes, a few have $7,595,777.43 but more likely the amount will be around $250,000). However, regardless of the final amount, they have arrived at retirement at a time when investment looks anything but easy — interest rates are low, and they have few ideas on how these nest eggs might usefully give them a retirement income safely.
Most of the financial literacy effort has been on teaching how to build a nest egg rather than how to use that nest egg for income.
In my investment advisory practice, I have seen multiple examples of poor investment behaviour. As a response to the pinch that these new or prospective retirees find themselves in, some have adopted a strategy of putting all their money in just one asset. For example they have purchased a rental property or continued to own a business. This means that they are not diversified but instead have concentrated their funds in just one asset class. And some are not having the retirement of their dreams. They stay on in the business as they kick the retirement can down the road, to pick it up (maybe) another day.
Others have ratcheted up risk by having portfolios with more shares than they ought; with returns from bank deposits and fixed interest investments virtually non-existent, they have turned to asset classes (shares and listed property) which look expensive but are at least doing OK for the time being. Repeatedly, I see people abandon balanced portfolios for growth portfolios and funds with less fixed interest and cash, but more shares and property.
Still others have simply held on to their term deposits, regardless of the paltry returns. The minimal returns they have been getting from the bank mean that to maintain any reasonable kind of lifestyle they are required to spend more capital. This, in turn, means that they run the risk of the money running out long before they do.
Of course, many people look at their options and, shunning retirement, carry on with work. That seems safer than putting their dearly beloved nest egg at risk.
To many retirees, accumulation of wealth was easy; it is the decumulation that is now necessary that is the hard part.
Diversify, diversify, diversify
In fact, there is a solution to the problem of investing in retirement, the same solution that people should always have adopted regardless of interest rates or valuations of other investments classes: that solution is to spread your money across all investment types and to get money into a range of different industries and countries. This is a diversified portfolio.
A diversified portfolio may not make you rich, but it is the best store of wealth ever invented. You may have built your wealth by concentrating your money to just one asset or asset class (you may have owned a business or some rental properties, or you may have invested aggressively in shares), but retirement is a time to lower risk as you start to enjoy what you have. Lowering risk means diversification.
There are plenty of options for diversification but that does not make it easy to choose which one. At the time of writing, there is only one fund that is a specialist drawdown fund, a fund designed specifically for retirees to invest in and draw out their money for a regular fortnightly income. (Disclosure: I am a director and shareholder of this fund.)
Other funds can be used to hold investment capital, which is then drawn on to provide a living. Many KiwiSaver funds are suitable for this, and other managed funds are also on offer from banks and fund managers.
A lot of people in New Zealand find it hard to get good advice. There are some very good financial advisers in practice but most only take on clients who have significant amounts of money (often the minimum is $250,000, but sometimes significantly more more). Those with $7,595,777.43 will be fine — every financial adviser in the country will beat a path to those farmers’ door.
But people with smaller amounts either need to go to a bank or fund manager and take advice from people who are advising on and selling only their own product. Regrettably, many people are simply left to their own devices.
All of this is complicated by the demise of the Defined Benefit superannuation scheme. These schemes, which started to be wound down in the 1990s, paid a percentage of finishing salary. Typically, employees would pay into these schemes and when they finished their careers as doctors, managers, teachers, etc., they would receive 60% of their salary until they died. These schemes were marvels of generosity — the contributions employees made went nowhere near covering the cost and left the government (in the case of public service employees) and companies (in the case of private sector employees) holding big liabilities.
Such was the cost, these Defined Benefit schemes were closed to new members. There are still plenty of people receiving them, but none is open to new members — the cost of paying a lifetime pension means no Defined Benefit scheme is ever likely to emerge again.
Now we are left to our own devices. Superannuation savings and KiwiSaver are now Defined Contribution (that is we know the amount we are contributing but not what will come out in the end). At the end of employment, we receive a lump sum according to what we have contributed, the amount that our employers may have contributed, and the investment returns that we got on the way through.
It is then our job to convert that lump sum into a pension. This job had been both so difficult and so expensive for Super schemes (with their investment experts and actuaries) that they had stopped doing it. But now we expect everyone to be able to do it themselves, without access to those actuaries and experts. That is a very big ask.
Drawdown — how much can you safely withdraw?
Given that we all have to look after our own money and investments now that there is no joining a Defined Benefit scheme, there are and will be problems. These problems of how to invest in retirement are in addition to that age-old problem of knowing how much you can reasonably draw from a portfolio. Even when retirees have invested their money well, they face the problem of figuring out how much they can take from the portfolio on a monthly or fortnightly basis so that the money will last as long as they do.
This is setting the right drawdown rate and it is critical to a good retirement. If you take too much from your portfolio, you run up against longevity risk; your money may not last as long as you do and you end up in your final years reusing tea bags and rationing the wine biscuits you eat for dinner. On the other hand, if you take too little, you forgo lifestyle — the children will benefit, at your expense, from your lower expenditure as you leave bigger inheritances.
There are two things that most people will have to do for a decent retirement:
1. You will have to invest in a diversified portfolio which, as will become clear, is no bad thing. No longer can people live on the interest from bank deposits and the likes, instead you will need to invest in a managed fund (or funds) and possibly enlist the help of a financial adviser.
2. You will need to spend not just the returns you get from investments but also some of the capital. This will mean that in retirement you will probably need to decumulate your savings, leading to smaller inheritances for the children.
This book sets out to help people with the way they should invest when the nest egg has hatched, and how they draw down from their savings to give a good retirement. These should be the best years of your life, but you need a happy fit between you and your money. Whether you have $7,595,777.43, or something more modest, you will have decisions to make.
As the reality of retirement strikes, there are a lot of people finding that although they had put some effort into accumulating a nest egg, they had never given much thought to how (and how fast) they would decumulate it. Now they need to.
Martin HawesOctober 2021
Introduction
The hardest thing to do in finance is to take a lump sum and use it to generate a good and steady income in retirement. It was always difficult but, in a world of very low interest rates, it has become even more so. For a long time, Kiwis have retired and largely used bank deposits to give them a retirement income. I doubt that this was ever a very good idea but now it is downright impossible.
In fact, it is not just interest rates that are low, but so too are dividend yields and rents. This is now at the point when few can take some capital and simply live on the income it generates. Instead, investors have to invest in a range of asset classes and draw an amount from that portfolio that allows them a good living.
The second hardest thing to do in finance is to decide how fast you will decumulate your savings, i.e. your drawdown rate. This book is really about the decumulation stage of life and the trick with this is to try to make your money last as long as you do.
Decumulation is a word that we are starting to hear more often as the baby boomers move into retirement. Most of us spend our working lives accumulating assets as we buy a house, pay off the mortgage, contribute to KiwiSaver and then, if we have done well, start to invest. All of this means that we accumulate wealth.
Come retirement, we then have to use the wealth we have accumulated to provide an income. Work stops (or at least slows down). NZ Super starts, but that is not enough to live on for most. We now need to use our accumulated wealth to plug that gap between NZ Super and the way we want to live. We need to find a way to substitute the income we had from work with the income we derive from the wealth we have accumulated.
In retirement, most people now truly decumulate as they run their capital down. Living solely on investment returns, and keeping all of your capital intact, now sits somewhere between difficult and impossible. We live longer, and a lot of people are very active in retirement (and therefore spend a lot). Unless you really do have $7,595,777.43 to live on, chances are you are not going to be able to leave a lot of your wealth to your children. You will need to start to decumulate.
It is this decumulation that is hard: not only do we have to make it last as long as we do, but we also have to watch our most precious savings decline — we have to take a hammer to our nest egg and chip away at it until it becomes next to nothing. In the decumulation stage, your wealth will gradually reduce as you eat into it. Chances are this will leave you feeling very uncomfortable about how long the money will last.
So, your decumulation needs to be set at the right rate — too fast and you will run out of money; too slow and you will have given up invaluable lifestyle during your best years. Deciding on that figure is hard.
Drawdown
The rate at which you take money from your investments is called the ‘drawdown rate’. I refer to the drawdown rate throughout this book. It is about setting a withdrawal rate at the right level so that you have a good life and do not underspend, but so the money lasts.
Calculating a reasonable drawdown rate is fiendishly difficult; it depends on:
• how you invest
• the returns that you get
• the vagaries of financial markets
•your tax rate
• inflation rates
• expenditure
• expenditure changes through retirement
• how long you are likely to live
• the state of your health as you progress through retirement
Calculating the right average drawdown rate across the whole population has any number of variables (e.g. life expectancy, investment ability, expenditure patterns, etc.) that need to be calculated (or guessed) for perhaps the next 30 years. Doing this for an individual, who may (but probably will not) be average for the variables, is even more difficult and subject to error. You are a sample of one and will probably prove to be nothing like the average.
We are all different and have different plans: some will happily let the cheque to the undertaker bounce as they go out on the last dollar, whereas others will want to leave everything they ever had intact to the children. Some will want to spend up large in the early years of retirement whereas others will be more cautious. Some will look at their parents and decide they will not make old bones while others believe they will live forever.
Actuaries, a profession of very clever people who are trained to make these kinds of calculations, have worked hard over the years to come up with several rules of thumb for a drawdown rate that will suit most people. Of course, they cannot account for you as an individual — although you may live the average time, it is more likely that you will live for a longer or shorter time than average. Moreover, your expenditure may be average overall, but you may decide to spend a lot shortly after you retire, or you may decide to spend less so that you have access to better healthcare towards the end of your life.
These rules of thumb are very useful, but they are not as good as a calculation that would personalise your drawdown rate. However, few people can make these calculations themselves, unfortunately — there are simply too many unknowns (some of which may even be unknown unknowns!) — so, in the absence of personalisation, it is best to work with the rules of thumb.
The 4% rule of thumb
Generally, drawdown rates are expressed as a percentage of the amount you have invested. For example, the most commonly used drawdown rates is known as the 4% rule. This rule means that at the beginning of retirement you can draw 4% of your portfolio to live on each year and increase this amount with inflation as you progress through retirement. If you do this, and provided your money is invested in a balanced fund (50% in shares and 50% fixed interest), the 4% rule of thumb says that your money will last for 30 years.
That would mean that if you had a balanced portfolio to the value of $500,000, in the first year you could draw $20,000 p.a. (i.e. 4%) and increase that so that your $20,000 p.a. keeps up with inflation and maintains its spending power. If you had retired at age 65, your money would last until you are aged 95.
There are several caveats with this rule. This and the other rules of thumb, regarding rates of drawdown, are discussed in chapter 4. Although these are all rules of thumb, and therefore a bit rough and ready, unless we can personalise a drawdown rate solely for you, they are the best we have to try to plan for retirement. Financial advisers will be able to refine this for you, but there will still be some unknowns (e.g. longevity, spending patterns and investment returns) and so, even when we try to personalise a drawdown rate, it will not be perfect.
Decumulation
As the baby boomers retire en masse, decumulation is becoming the word of the day, and I now know few people who plan to leave a lot of their investment capital behind as inheritances. In fact, the great majority of people I talk to plan to leave the house for the children, if they can, but to spend both investment returns and the capital itself in retirement. This seems to me to be a significant shift over the last 10 years or so.
Letting the cheque to the undertaker bounce
Decumulation will inevitably have an impact on what you leave behind. Our children may be enjoying very low interest rates on their mortgages at the moment, but the flipside of this is that we as parents are having to spend what might have been our children’s inheritances. And many of us are going to make retirement the time of our life, go out on the last dollar, and let the cheque to the undertaker bounce! Some people may try to spend just their investment returns, but when that is not enough, they will have to spend their capital as well.
I have long had an interest in this decumulation phase. My interest was piqued because there are technical aspects to making sure a portfolio is well invested, but there are also behavioural issues. This book makes a strong case for diversification in retirement (in fact, I think it essential that retirees diversify) but many people find changing the habits of a lifetime difficult. Some people have invested in a particular way (e.g. they have owned some rental properties) and do not see any need to spread their money more widely when they are older — they would prefer to hug the familiar. However, you may be retired a long time, and anything can happen over that time. You need to own different asset classes so, regardless of what the economic weather, you always have some investments that will do well.
The great mismatch
In a world of low interest rates, we must use volatile assets (shares and listed property) to meet our demand for a steady income. This is a mismatch; normally you would not try to get a steady income from a portfolio that contained a lot of volatile assets. However, because interest rates are so low, there is no alternative — you must have some shares and listed property in your portfolio or fund. It would be easy if we could match our requirement for a sufficient and steady income with an investment which was sure to provide that, but such an investment does not exist.
Unless you took a government fixed interest investment with a maturity in 30 years (which should see you out), you cannot be certain that you will get the expected return. Such an investment is, of course, not a starter because at the time of writing, the interest rate would be just 2.3% and, after tax, this is unlikely to even keep up with inflation — after (say) 10 years, your nominal income would be the same, but its spending power would be diminished.
And so, we have to add other investments (especially shares and listed property) to give higher returns. Unfortunately, but inevitably, these come with volatility. Investors only get paid for taking on risk — and the more risk they assume, the better they are paid (i.e. the better the returns).
This book does not set out to know the unknowns — no one knows what investment returns will be next year, nor can they know when they will die. Instead, this book tries to manage these unknowns and mitigate their effects, and to manage volatility and the variation of returns, which come from a portfolio that has shares and listed property in it.
All this difficulty (good investing and prudent drawdown rates) comes at a time when you should be looking forward with pleasure to your 20 good summers. However, people often face a worrisome set of decisions. These decisions are exacerbated by two things:
1. You have to work your way through a tightly woven cloth of vested interest. There are competing claims and opinions, and this all comes at you in brand new language, which you may never have learned.
2. Everything is on the line. In retirement there is no time to rectify major mistakes — one false move and everything you have worked for can be lost.
Little wonder that people are nervous when they move to crack open their nest egg.
Diversification
Throughout our working lives there are all sorts of people giving advice or commentating on saving for retirement — people telling us about property investment, KiwiSaver, how to save, etc. However, although there is plenty of advice on accumulation, there is very little comment or advice on managing your money in retirement.
And so, retirees cast around for options. With the easy option of putting their money in the bank and living off the interest completely gone, they look for alternatives.
My strongest advice for people who are going into retirement is that they diversify their savings. They may have made their money through a single asset type (perhaps their own business or a property portfolio) but the thing that made the money is not necessarily the best way to hold on to the money. When you are young you can afford to take risk — and so you may have put all your eggs in one basket. With a bit of luck, all will be good. However, when you come to retirement you cannot push out risk — you cannot bet everything on just one thing.
It is always tempting to stay with the familiar, but there is no single asset class that will hold your money safe through all the years of retirement. A big part of this book is about investing your retirement savings for income — and diversifying is a key theme.
By the time you have got to retirement, the get-rich game is over. Now is the time to play stay-rich. And there is only one place you should look to put your money in retirement — a diversified portfolio.
Get some help
I think most people should have their investments managed for them rather than the old idea of taking a DIY approach. Having your investments managed for you could take one of two forms: either you invest by way of a managed fund (or, perhaps a range of managed funds) or you have a financial adviser put together a portfolio and manage it for you.
Investment is a lot more complicated than it used to be; there are more options for your investments and more choices to be made, meaning that there is little scope for DIY investors who are not very well informed and not prepared to put a great deal of time into investment strategy, investment selection and investment management. I have looked at many DIY portfolios over the years and found them lacking in many respects, and I now look at chat sites used by many young investors who have just come into investment. I am often appalled by the lack of knowledge.
Although DIY may be reasonable for younger people with smaller amounts of money that they can afford to lose, it is completely unreasonable for a retired person whose portfolio is their means to living a good life.
It is likely that a professionally managed fund (i.e. KiwiSaver, a drawdown fund, or other managed fund) will have a performance that is better, and this superior performance should more than compensate for the fees you pay. I recently read of a US study by fund manager Vanguard which showed that over a 25-year period an adviser-managed portfolio averaged 8%, while a self-managed portfolio returned 5%. Professional management pays.
That difference would pay the fees with a lot left over, and most people I know would be better off with a professionally managed investment portfolio. This includes myself — even though I know quite a lot about investment, I do not want to spend a lot of time staring at a screen and so I now have someone investing my money for me.
The book is divided into two parts: the first concerns some of the most important planning issues. I have called this section ‘Planning for your best retirement’ and it covers some of the key planning issues that must be addressed. The second section of the book is called ‘How to invest in retirement’ and it covers the most important aspects of investing in retirement (which is quite different from investing for retirement).
Section 1 — Planning for your best retirement
It is tempting to go straight to the matters that are in the second section of this book — that is, how we should invest our money. Unfortunately, in doing this you ignore some of the big issues that need to be thought through and planned for. These planning issues are dealt with in the first six chapters which cover:
• Money management, spending capital and making the transition;
• The amount you can draw from a portfolio;
• Your levels of expenditure and, importantly, how this will change over time; and
• Consideration of housing and how that may be used to either free up some capital for more investing or how the house itself may be used for income.
