Part 2: Building a better retirement nest egg: factors that influence retirement savings

Written on the 23 November 2016 by AMP Capital

This is the second in a two-part article series that examines the factors that contribute to building retirement savings.

Many factors have the potential to change retirement savings outcomes, each with varying degrees of influence. It's important for SMSF investors to understand how these variables work to help maximise retirement savings.

This is the second in a two-part article series that examines the factors that contribute to building retirement savings.

Part one showed how investment returns and appetite for risk make a considerable contribution to retirement savings. Compounding has an exponential effect on the size of super fund balances at retirement. AMP Capital research into the experience of the standard Australian worker shows investors who fare best overtime are those who meet the three criteria below.

Stay invested in the market: all investment categories (conservative to aggressive) delivered significantly better returns than staying in cash.
Invest in growth strategies early in their career and benefits from the compounding of these higher returns to build balances.
Select an appropriate active manager. An improvement in returns of as little as 0.1% a year has a significant impact to the retirement balance, compounded over a working life.
This analysis assumes a standard worker is one who works fulltime from 20 and receives average earnings that grow at the historic wage growth rate of 3.5% p.a. (as measured by the Australian Bureau of Statistics). It's assumed the worker invests in a traditional balanced fund, a proxy for which is provided by the average of the Morningstar Growth Category.

This analysis suggests having the right investment strategy is particularly important for workers who are unable to easily increase their contributions. By improving investment returns, through an appropriate asset allocation strategy and active management, the size of the total retirement nest egg is less reliant on contributions.

The importance of early returns and late risk management

Younger savers are affected less by market corrections because they have time for investment conditions to recover and they still have future contributions to make that aren't impacted by the drawdown.

According to AMP Capital research, an investor who suffers a 25% loss at capital at 30 is expected to have a 0.8% reduction in their retirement balance. Even at age 50, a 25% drawdown is only expected to have a 7% impact on a savers balance at retirement. At age 60, the impact has exponentially increased to 17%.

Due to their time advantage, young investors are relatively immune to the negative effects of market corrections. Conversely they also benefit much more from compounding returns than older savers. High returns for younger investors help build a larger pool of savings, which then compound at higher rates. Younger investors also don't have immediate access to their savings so are also less likely to exhibit counterproductive behavioural biases such as impulsively reacting to market weakness by withdrawing their money from the market.

Young investors have a high capacity to bear volatility, have a long investment horizon (enforced by regulations that prohibit access to their savings) and receive disproportionate benefits from returns. Consequently, younger investors benefit substantially from pursuing a more aggressive asset allocation than older savers.

The importance of the investment horizon

Many aspects of investing only hold true over the long term. Over a short time horizon, say a day, shares don't reliably outperform conservative investments like cash. However over longer time horizons riskier investments consistently outperform more conservative assets. For instance, on a daily basis, shares deliver a positive return 53% of the time. Over a longer six-year investment horizon the S&P/ASX All Ordinaries Total Return Index since inception has delivered a positive return 99% of the time for Australian share investors. Similarly, there is no 10-year period on record where the S&P/ASX All Ordinaries Total Return Index underperformed CPI+3%.

Historically, after dividends are captured in returns, the probability of loss for equities sharply declines. This dynamic is called 'time diversification' because over longer time periods, investors will experience a variety of different market conditions.

Comparing the performance of different risk profiles paints a similar picture. Over short time periods such as a month funds with a higher allocation to growth assets outperform 60% of the time. Over a five-year time horizon higher risk funds outperform 75% of the time. To reliably receive a benefit from moving into higher risk profiles investors must have a long investment horizon which, at a minimum, is greater than five years.

Investors who have long investment horizons can typically rely on the risk premiums of different asset class to consistently deliver performance. They also are less sensitive to an enduring drawdown due to the benefits of time diversification. However in periods of less than five years investors shouldn't rely on a typical diversified fund to deliver the performance they expect and could consider alternative multi-asset styles of investing which focus on protecting against drawdowns.

Original Article