The aim is to try not to run out of money before you run out of life
Following on from previous articles about pensions, KiwiSaver and superannuation we explore the concept of utilising a capital accumulation and spending plan over the course of your natural life expectancy.
The aim is to try not to run out of money before you run out of life. Traditional pension plans have the advantage of providing certainty in this regard; however, for New Zealanders there is not a lot of choice when it comes to pension providers. As commented in previous articles, defined benefit superannuation schemes (pensions) went out of favour after the 1987 share market crash which sent NZ into an extended recession.
The Self-Managed Pension Concept has been developed by financial planners over several decades. It uses investment liquidity to create a steady cash flow from investments for the benefit of the client. This means that a client receives a smooth cash flow rather than relying on investment income which tends to fluctuate and be paid in uneven lump sums.
In periods of low interest rates, which we have experienced over the past decade, relying on fixed interest income has been unsuitable as a means of topping up retirement spending. Investment returns are made up of income distributions and capital gains of which the latter has been the mainstay over this period. Capital gains are also more tax efficient for investors who take a longer-term approach.
The key to this concept is a diversified portfolio of assets and a high level of relative liquidity. New Zealanders love affair with rental property is a good example of low liquidity. If you want to fund an overseas trip you can’t sell the kitchen or bathroom to realise the cash to do so. A diversified portfolio of assets can be arranged in buckets of varying liquidity and risk to meet short, medium and long-term spending requirements. Risk or uncertainty is squeezed out of diversified assets over time, and it is much easier to predict portfolio returns over a longer duration.
With many clients, drawings are at such levels that it is expected the capital base will diminish. This is done on purpose so that they maximise their lifestyle choices and enjoyment. It is important to monitor lifestyle choices so that clients don’t spend down their capital too quickly and to ensure they receive their full entitlement to any state provided benefits when and if they are eligible.
There is a certain amount of tailoring that can be advantageous to clients using this concept. Generally speaking, the early years of retirement are the most expensive. This coincides with more active lifestyles brought about by continued good health. Travel and spending time with grandchildren are high on the agenda. Regular withdrawal payments, during this period, are set at higher levels.
As time progresses these priorities diminish and clients transition into a more reflective stage of life. Drawings are then reduced and there may be a desire to pass on a financial legacy to the next generation(s).
What if there is a market correction such as the 2008 global financial crisis? There will inevitably be years when portfolio returns are negative.
Again, it is about cutting the cloth to suit. Experienced advisers were able to manage their clients’ expectations and in some cases counsel them to reduce spending until market valuations recovered.
The development of wrap account structures for holding investments has enabled this concept to be put into practice with a high degree of efficiency and transparency.
The Self-Managed Pension Concept is designed to remove the stress clients’ may feel when managing their own financial affairs. It is a collaborative decision-making process, with a skilled financial adviser providing regular reviews and modelling options where spending can be adjusted up or down.