12 December 2017
Don’t just drawdown your KiwiSaver to fund your retirement
‘Buy-low and sell high’ is everyone’s number one investment goal but it’s almost impossible to achieve consistently in markets prone to erratic swings in either direction.
Instead, rather than trying to choose the right moment to get on or off the market rollercoaster, many people aim to build up long-term savings using ‘dollar cost averaging’. This is when, just like KiwiSaver, you drip-feed regular amounts of money into your retirement fund (e.g. $100 a week), regardless of market conditions.
This disciplined steady-as-she-goes approach removes the risk of investing a large amount of money on the wrong day and the angst of second-guessing market movements.
Some days you buy-high, other days you buy-low but, according to US retirement planning specialist, Henry Hebeler, usually “the advantage of buying more shares at a lower price more than offsets the disadvantage or buying fewer shares at a higher price”.
For example, let’s say you’re in KiwiSaver and contributing $1,000 a month to your fund. One year there a market downturn and the value of your fund falls by 30%. Dollar cost averaging means you’re taking advantage of these falling prices by buying more units in the fund.
The table below shows that by investing the same amount each month, regardless of the price means you buy more at a lower price and less at a higher price. This helps you improve the performance of your investment. At the end of the year, you’ve invested $12,000 and bought 1,889 units now worth $7 each with a total value of $13,220. What this means is that you’ve actually ended the year with a 10.2% gain, despite a 30% drop in your fund’s value.
But if dollar cost averaging increases the odds of reaching your savings goal, the same strategy has the opposite effect when you draw down those funds during retirement. It’s time to meet its evil twin: ‘reverse dollar cost averaging’.
Typical retirement strategies that rely on selling, say, 4 per cent of an investment portfolio each year to generate regular income can deplete savings faster than expected, as dollar cost averaging plays out backwards – a result that is magnified during market downturns.
Let’s see what happens when we reverse our earlier example and you draw down $1,000 a month from your KiwiSaver fund.
Drawing down a constant amount in a falling market means you need to sell more units in your fund to get the same amount of income.
For example, in the table below, you are selling twice the number of units in June as you were in January to get your same $1,000. This has the effect of exacerbating your investment loss for the year. Although your fund has fallen by -30% across the year, your withdrawals have increased this to -43.2%. If your investment at the start of the year was valued at $100,000, it would now be worth only $56,779.
So what can you do to manage this risk?
Well, you could take a more active approach to managing your investments and choose to sell only when markets are high. This approach is attractive in theory but quickly runs into some practical difficulties.
Following this strategy, you will have to make exactly the sort of market-timing calls that flummox even the most experienced investors. Furthermore, if you choose to hang on to investments during, possibly multi-year market downturns you must inevitably give up the income that sustains your lifestyle.
Of course, another way to solve the problem would be to sell all your ‘risky’ assets like shares in exchange for the apparent comfort of cash or term deposits.
But, according to Wade Matterson, from global actuarial firm Milliman, heading to the safe haven of bank deposits is a poor solution for retirees facing longer lives in an era of low interest rates.
“You either accept that people have to de-risk as they get closer to retirement, which means accepting lower rates of return on conservative assets,” Matterson says. “Or you take the view that they need to take on more exposure to growth assets likes shares – but if so, how do they deal with market volatility?”
He says retirement products that include an element of income insurance while retaining exposure to the share market (and its higher rate of return) offer a means of escape from this “risk paradox”.
Lifetime was created to solve this problem. It aims to give you higher returns by investing your money in a balanced fund of shares and bonds. At the same time however, your income is insured and guaranteed for life, meaning you won’t be held captive to the savings-depleting effect of reverse dollar cost averaging. Regardless of market returns or however long you live, you receive a regular pay cheque every fortnight, for life.
What could your income be?