Financial life cycle paradox

Written by Michael McAlary

Changing lifestyles combined with increasing life expectancy have outgrown traditional retirement planning models. Michael McAlary from WealthMaker Financial Services outlines how the Aspire product addresses this new dynamic.

Increased life expectancy

Over the last 50 years a person’s life expectancy has increased by around 12 years. A child born today will live until they are in their early 90s. The reasons Australians are living longer include better diet, improved medicines and living conditions.

In addition to everyone living longer, people are delaying significant life events. Australians are getting married and starting families later and having fewer children. Higher property costs means that children are staying at home longer and this is reflected in the increasing age of first home buyers. Many of these decisions regarding lifestyle are made because of someone’s financial position.

Economic structural changes

There have also been structural changes to the Australian economy that are impacting on an individual’s ability to save and invest for their future. Notably, Australia has increasingly become a high cost of production economy and to compete internationally we must improve our skills and qualifications. Australians are therefore, spending more time at school and in tertiary/vocational training at a financial cost to themselves. Even with Government assistance to fund tertiary education many young adults are starting their working years indebted.

Another major structural change occurring is the increasing trend to casual or part time work. Until the early 1990s it was common to have a job with one organisation for life. Today, this is rare and it is expected that people will change not only jobs 4 or 5 times in their career, but also the industry. This trend to part time or casual work, particularly amongst older workers means their pre-retirement incomes are lower, limiting their ability to save.

Wealthmaker Financial Services has analysed these trends and structural changes, producing some telling ratios that have implications not only for financial institutions, but every Australian.

 

Sources: CIA World Fact Book, World Bank, ABS School Statistics Census, Australian Bureau of Statistics. Averaging has been applied to cover the differences, e.g. males versus females.

 

The table contains 3 important points for all of us:

  • Income earning/life expectancy - In 1960 the average Australian spent 61.7% of their life working, whereas today it’s only 42.7%. This means that Australians have less time in the workforce, and therefore a reduced timeframe to save and invest for their retirement.
  • Retirement/life expectancy - In 1960 the average Australian was expected to live for 8 years after they retired. Today it’s around 22 years.
  • Income earning/retirement - In 1960, an Australian had 5.5 income earning years to save or invest for each retirement year. Today the ratio is 1.6 earning years. An individual must save enough during their income earning years to pay for 22 years of expected retirement.

As our income earning years are decreasing and our retirement years are increasing the current level of superannuation savings is insufficient. The Federal Government is taking some action to address this by proposing to increase the superannuation levy, however, this only goes part of the way. Australians will have to work longer and may have to accept a lower standard of living both before and in retirement.

Life cycle products

Financial institutions need to consider these trends and develop products that address these issues, rather than amending existing products as the solution. For example, fifty years ago the longest home loan term was 25 years, today the most quoted home loan term is 30 years, although it is possible to get them up to 40 years.

In recent times, superannuation and investing for the future have been the focus of public debate; specifically the trend towards lifelong investments and products which reflect the different phases of someone’s life stage. Paying off home loan debt, investing for one’s retirement from an early age and investing in different asset categories has never been more important than today.

One solution receiving some focus recently is life cycle funds. These funds follow a predetermined investment plan with the asset allocation changing according to an investor’s age. The investment strategy at the start is aggressive and risky which allows for higher returns to be generated in a investor’s younger years, and it becomes more defensive as they move towards their retirement with the aim in the later years being to protect capital.

This type of fund does not guarantee sufficient funds on retirement, because the decision to switch funds is based on someone’s age and not the economic cycle. This represents a major risk, as just when investors should be increasing their exposure to risky asset classes in line with the economic cycle their investment is being switched to cash based products because of their age. Active portfolio management can somewhat ameliorate this risk. However, there are other risks that need to be considered. These are, Investment Risk, (i.e. poor investment returns or loss of capital), Longevity Risk, (i.e. insufficient funds on retirement) and Sequencing Risk, (i.e. the order of the investment returns over the term of the investment).

Equity re-draw

A well-known investment strategy is to pay down your home loan quickly and then draw on equity in your property to invest further. The difficulty of this strategy is that it may not be enacted until after several years into your loan. Specifically, any property valuation needs to support the Loan to Value Ratio and the borrower must be able to service the increased debt.

Aspire - A life cycle product

Aspire replicates the home buyer’s life cycle. In the early years the focus is primarily on debt reduction, while in the later years and consistent with life time investments, the product allows customers to be debt free and have an investment portfolio, i.e. Aspire moves from being a home loan to an investment.

Sound wealth creation comes from asset diversification, and with Aspire a customer owns their property and the investment in equities.

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