4 things to know about risk and retirement income

Risk. Reward. Repeat. That's the secret sauce of how some people create wealth over time, versus those who don't. Alex Brooks helps explain why knowing your risk tolerance is vital, especially if you want to retire one day.

By Alex Brooks

Tolerating risk usually leads to reward in long term investing.

That’s why your own personal understanding of risk is key to help plan the right retirement for you.

The more you understand risk and how it impacts money, particularly superannuation, the more you can optimise towards the retirement income you want.  

‍Is avoiding risk a good thing or bad?

Avoiding risks like accidents or bad health outcomes is good.

But avoiding risk is definitely not good if you want to maximise returns on money over time.

According to experts, one of the biggest financial risks in retirement planning isn’t investing in a volatile portfolio, but rather avoiding risk altogether.

People who think they can ‘set and forget’ investments will typically pay higher fees and accept lower rates of return.

Cutting out 1% in fees and upping expected investment returns by 1% will double your retirement income over a 35 year time frame, according to this submission to Treasury on retirement incomes.

Nobel-prize winning economist William Sharpe says even asset management fees of just 1% (the average amount charged by MySuper funds) will ultimately chew away one-tenth of future income.   

Therefore, people who understand the concept of risk, and how it applies to investments inside and outside of super, should be able to make better decisions about their future retirement income.

‍Risks in planning retirement income

There are many different types of financial risks - currency risks, inflation risks and so on - but generally, risk is the chance an outcome will differ from what’s expected.

Retirement income risks include:

• The possibility of losing some or all of your retirement income when investment markets go down
• Not getting returns you want during the accumulation years
• Paying higher fees than you should during the accumulation or de-accumulation years
• Living longer or for less time than you expect, which can lead to not having enough money or not optimising how much you can spend on lifestyle - this is sometimes called longevity risk
• Economic shocks like stock market crashes or periods of high inflation
• Government policy changes to Medicare, Age Pension eligibility, aged care or income taxation rules.

Risk can be ‘quantified’ to general circumstances (like those described in the bullet points above) or it can be tailored to your own personal circumstances (such as if you have a disabled child to care for or have a goal to travel the world in retirement).

This article will help you understand why knowing your risk tolerance towards retirement income can help you plan better.

‍What’s your personal view of money and investment?

Personal attitudes to money and the way role models like your parents or grandparents behaved around money and investing can be more important than we think.

How much we understand about ‘money’ - our financial literacy - can influence our ability to save, invest and make financial decisions that improve our wellbeing.

For example, do you consider yourself a saver or an investor?

Savers tend to take very little risk - using bank accounts or term deposits with fixed rates of returns - to build savings slowly.

Investors tend to put money into things like shares or property, which can be more volatile over time. They take higher risks to get better returns.

Saving is more about ‘putting money away for your future’ whereas investing is about calculating the risk of foregoing what you can spend today for higher returns in the future. 

Risk is intrinsic in all investments. 

It’s also fundamentally important to planning for retirement in Australia.

‍Risk is baked into our superannuation system 

What you need to remember is that risk can have very real impacts on older people who need their superannuation or investments to turn into retirement income.

Australian superannuation funds lost 21% of their value between September 2007 and March 2009 during the Global Financial Crisis.

At that time, people invested in higher risk allocations would most likely have had lower balances than those with conservative allocations.

So people who needed to turn their superannuation lump sum into an annuity or pension between September 2007 and March 2009 would have suffered lower retirement income opportunities than people who turned their superannuation lump sum into retirement income at other times.

On the flipside, people tolerating higher risk could have delayed ‘cashing in’ their super and given it more time to recover to the post-GFC market results delivered today.

‍Risk consideration 1: every Australian with superannuation is an investor  

Many Australians don’t realise they are investors by default, because Government policy insists employers put 11% of what they earn into a superannuation fund.

Most of us ignore our superannuation until we get older and realise how valuable it could be.

Anyone with superannuation is effectively an investor, with their money invested in different asset classes, usually allocated by their super fund.

There are default MySuper funds to allow for disinterested investors who have super to be enrolled in a cost-effective ‘balanced’ superannuation product that charges 1 to 1.5% or so in fees.  

Many super funds allow you to choose your own ‘risk’ profile, so you can decide whether you’re prepared to see your super balance fall in exchange for larger gains over the long term.

This means you can choose to take a higher risk to get higher returns - but only if you truly understand your risk tolerance.

These ‘risk’ levels for superannuation investment in Australia are usually:

• Aggressive or extremely volatile investments that can spike up or down in short timeframes but may ultimately deliver superior returns over a long timeframe.
• Growth for higher average returns over the long term, with the potential for elevated losses in challenging years compared to lower-risk alternatives.
• Balanced for reasonable return for mitigating risk and minimising losses in adverse years.
• Conservative minimises the likelihood of negative returns compared to the balanced or growth options.

Asset allocations:

• Cash would mean you have 100% invested in deposits with Australian deposit-taking institutions or a 'capital guaranteed' accounts. In Australia, the Financial Claims Scheme (FCS) ensures you will always preserve up to $250,000 per account-holder - use the deposit checker on APRA's website. 
• Ethical focuses on excluding investments in companies that fail to meet specific environmental, social, and governance standards. The ethical option is flexible across the risk spectrum, ranging from high growth to conservative and is an increasingly popular choice.

Deciding your own risk tolerance, rather than letting a ‘default’ MySuper fund choose it for you, can allow you to alter the trajectory of your superannuation balance over time.

Speak to your superannuation fund about the risk options available on your super fund. Sometimes this is called ‘investment choice’. Call the number on your last superannuation statement to ask them about it.

‍Risk tolerance consideration 2: diversification helps avoid - or hedge - risk

Risk can be managed by diversifying your investments across different asset classes.

This is sometimes also called a ‘bucket strategy’ where you allocate some of your capital to a high risk investment and keep other amounts in safer assets.

In other words, you could invest in 3 different asset types - say, derivatives, cryptocurrency and the stockmarket. 

You can ‘hedge’ the risk of crypto prices - which are highly volatile and sometimes even scammy - against the price of shares, which are less volatile. 

Being invested in different asset classes and understanding their risk profiles can change the amount you end up with in your pocket on the day you decide to ‘cash out’ and take an investment as money you can spend.

‍Risk consideration 3: timeframe, volatility and retirement

If you want access to your money in a short timeframe - say 1 to 3 years - the general rule is you should take less risk than someone who wants to invest over a longer timeframe. This is because you will have less time to ride out market corrections (such as a big fall in returns).

The closer you get to retirement age, the more likely it is that people tend to steer towards conservative strategies that preserve capital. That’s not the case for everyone though! For example, read more about Peak Pension and how to understand the Age Pension.

It’s important to understand that general advice doesn’t apply to everyone! And that’s where getting personal financial advice can really help. Read more on MoneySmart about paying for personal financial advice. You can also ask your super fund or the Government Financial Information Service.

Investing (and risk) for retirement income is different to investing to buy a property or investing in shares. There are risks in choosing the wrong account-based pensions, annuities or savings strategies for retirement income, too.

Read more about 9 non-nonsense tips to invest for the long term.

‍Risk tolerance consideration 4: use free tools to work out how much risk you are prepared to tolerate

MoneySmart have a super calculator that shows you how your risk tolerance can change you superannuation returns (Change the investment option in the drop-down and compare the estimated super balance.)

You can also use MoneySmart's investor toolkit quiz to get recommended reading based on your financial literacy.

AMP has a risk profiler tool you can explore to find out your general risk tolerance to investment. (Answer the prompts and select the answers - reset the answers to compare the result.)

To find out more about calculating your retirement, read Citro's detailed reviews of superannuation and retirement income calculators. You can also understand the 3 enriching phases of superannuation and how super turns into income.