Insight

Drawing down on your super - rewards and risks

25 November, 2019

You’ve spent your life accumulating your super and now you’re nearing retirement and the next phase of your life.

What are the options for transitioning to retirement and, once you retire completely, how can you avoid the risk of your super running out before you do?

Transitioning to retirement

For some people, stopping work and going straight into full-time retirement is a good option. For others, a transition to retirement strategy gives them more time to save for retirement or additional emotional stability by slowly easing into retirement.

By using a ‘transition to retirement pension’, you can access between 4-10% of your super balance each year, as long as you’ve reached your preservation age, even if you’re still working.

A transition to retirement strategy can be rewarding in two ways:

1. Reduce your working hours 

A transition to retirement strategy allows you to supplement your income by drawing a regular pension payment from your super fund. You could choose to reduce your working hours, and replace lost salary with income from the transition to retirement pension.

2. Save money by reducing your tax bill

Or, you could continue to work full-time but reduce your tax by salary sacrificing some of your income into super and supplementing your cashflow by taking a pension. That is, you contribute part of your salary to super (where it is taxed at a maximum of 15% rather than at your marginal tax rate) and then move your super money into a transition to retirement pension to draw pension income to supplement your reduced salary. The tax-effectiveness of the pension payments, provided you are over age 60 or you have a tax-free component, will help lower your overall tax bill.

Retiring full-time

Once you decide to retire full-time you can take your super as a lump sum, start an account-based pension, also known as a retirement phase income stream, or a combination of both. The benefit of starting an account-based pension is that it provides a regular income with minimum pension payments each year, which is calculated according to your age. Unlike a transition to retirement pension, there is no maximum payment amount.

Tax benefits of account-based pensions:

  • An account-based pension can be more tax-effective than taking your super as a lump sum.
  • The earnings from investments in your account-based pension are tax-free. These tax-free earnings remain in your account and increase the account balance.
  • And, both lump sum and pension payments from your account-based pension are generally tax-free once you turn 60.

The maximum an individual can use to purchase an account-based pension is currently $1,600,000.

Avoiding the risks

How long your pension lasts depends on what you want to do in retirement, how much super and other investments you have, how much you withdraw each year, the investment returns and the amount of fees. So, careful planning is important.

Your account-based pension can include a range of investments including direct shares, fixed interest, term deposits, cash and managed investments — depending on the investments offered by your fund. And, as with any investment, there are risks that need to be considered and managed.

Longevity risk

Unless you have a defined benefit super scheme, there’s the risk of your money running out before you do. With life expectancy increasing, it’s important to plan for more years in retirement than you might think. For instance, if you’re looking to retire at age 60 in 2024-25, you are likely to live to 87 if you’re male and 90 if you’re female. That’s about thirty years in retirement. This long timeframe means an allocation to more volatile ‘growth assets’ such as shares and property should be maintained to reduce the longevity risk.

Inflation risk

Inflation risk is the risk that your investment returns do not exceed the inflation rate and so your money doesn’t buy as much as you expected it to in the future. It’s important to choose investments that provide returns that are likely to exceed inflation without taking too much risk – generally, growth assets.

Investment risk

Investment risk, particularly for retirees, is important because you need to make sure you’ve got the right balance of growth assets for your long-term needs, and defensive assets, such as cash and fixed interest, for your short and medium-term needs. As you get older you will likely be advised to move more of your investments into defensive assets to reduce the risk of not having enough time to recover from losses. And that’s where sequencing risk comes in.

Sequencing risk

Sequencing risk refers to the impact the order of annual returns can have on the total value of your portfolio when there are withdrawals from the portfolio. The more volatility there is and the larger the withdrawals, the greater the sequencing risk.

When you draw down on your super, lower returns or losses early in this period are worse as they are on a larger balance and there is less money left invested to recover the losses. This can be a key concern for those about to retire.

To manage this risk, it is essential to have your defensive assets separate from your growth assets, rather than blended in a single managed fund such as in a ‘balanced’ fund. In doing so, you have the flexibility to fund pension payments from the more stable defensive assets when your growth assets have a temporary fall in value — allowing them the time they need to recover.

John Dacker, Shadforth adviser in Sydney says:

You should ideally hold a buffer of five to seven years-worth of expected pension payments in defensive assets such as cash and fixed interest to reduce the risk of being forced to sell growth assets before they have recovered from a large fall in value. This buffer should ideally be built up during the 5-10 years prior to retirement.

Case Study

Bethany is planning to retire in two years. She has super investments made up of 80% in growth assets and 20% in defensive assets through a diversified managed fund. Beth only has two years before she needs to start to draw down on her super and it is expected that she will draw 5% per annum from her account. As such, her financial adviser recommends that her investments are re-arranged slightly so that at least 25% (5 years x 5% pa) is held in defensive assets and that they are in a separate investment to her growth assets. As Beth gets closer to retirement, her adviser may suggest increasing the amount in defensive assets to 35% (7 years x 5%). This means the next time the growth assets have a large fall, they can be left alone to recover some or all of their losses for at least 5-7 years.

If you’re nearing retirement and need to put a plan in place please contact us. We can help you manage your transition to retirement and help you manage investment risks.