Does your investment strategy manage frailty risk?
Investment decisions are an important part of running a self-managed superannuation fund (SMSF) but to make good decisions you need skill, advice and an investment strategy. This applies equally in the accumulation phase and the retirement phase.
A documented investment strategy is required under legislation. Its aim is to guide investment decisions with consideration to the investment objectives and risk profile of members. The strategy needs to consider the potential returns and specify asset class investment ranges. But in the retirement phase, it also needs to ensure liquidity to draw the level of required income as well as pay expenses.
Planning how your retirement years may play out can be an exciting proposition but also presents challenges for the development of an investment strategy.
While you can plan how you want retirement to look, you can only guess how long you will have and what your health and capabilities will be like. The uncertain question is then how much you will need to accumulate to secure your preferred retirement lifestyle and the level of investment risk you can afford to take.
The historical approach taken by most people is to assume a flat (or declining) level of income which grows with inflation, noting that a minimum level of income needs to be drawn from an account-based pension. But this approach exposes a flaw, as expenditure needs throughout retirement are unlikely to be evenly spread.
The three phases of retirement
Instead of treating retirement as one homogenous phase, it may be more realistic to consider retirement in three life phases: the active years, the quiet years and the frailty years. This third phase is often a forgotten, or ignored, pillar of retirement.
Phase 1 is the initial period with ‘active’ years to focus on travel, spending time with family and friends and basically loving life! Health and wellbeing during this time are good, and the income needs in this phase of retirement may be higher due to the cost of leisure and lifestyle.
Phase 2 includes the ‘quiet’ years when health starts to decline. You may still maintain living independence, but spending may start to decline as you start to reduce your lifestyle spending.
Phase 3 is the ‘frailty’ years when you start to experience either a physical or cognitive decline that means you need help with daily living activities.
The reality is that we are all likely to experience some cognitive decline or lose some of our physical ability as we age. This is a natural process but does not mean we will all develop dementia or lose the ability to live independently. It may be a short period of weeks or months or could span over several years.
Impact of the third phase
Statistics from the Australian Institute of Health and Welfare show that this third phase can, on average, account for 17%-25% of our retirement years. The cost of accessing aged care services in this period can start to push up again your required level of income.
While we don’t know how long we will have in retirement or what retirement will bring, we can expect to experience a period of frailty before we pass away. Spending patterns are likely to vary over these three phases and this requires consideration when designing your SMSF investment strategy.
If you consider the cost of care in the third phase, the pattern of income needs is more likely to look like a smile than a straight line.
Managing frailty risk
When planning for retirement and calculating the required level of savings, two key retirement risks are often considered – longevity and sequencing risk. Longevity risk is the chance of living longer than expected and outliving your savings. Sequencing risk is the impact that volatility of investment returns may have on the duration of savings.
However, the third pillar– frailty risk – is often ignored and may cause savings to run out earlier than anticipated, exacerbating the longevity risk. Your SMSF’s investment strategy needs to consider the changing income requirements in each of these phases and may require adjustments to asset allocation and investment choices as you progress through the phases.
Managing frailty risk should take into consideration:
How you expect to fund aged care costs – recognising that legislation has been shifting towards an increased user-pays basis
The role of your home in meeting aged care costs – including your willingness to access the equity in your home
Your ability to rely on family and friends to provide care and financial support
If you need to move to residential care, what options you have for funding the accommodation deposit and ongoing costs.
These are complex decisions that are important to discuss with your financial planner. Aged care personal advice and planning ahead to create a secure and comfortable retirement throughout all phases of your retirement – including the frailty years.
Disclaimer: The information in this article is general and does not take into account your particular circumstances. We recommend specific financial, tax and/or legal advice be sought before any action is taken. Aged Care Personal Advice is a registered business name of Aged Care Steps Pty Limited ABN 42 156 656 843, AFSL 486723.