In this guide
No matter whether you’re about to start your first super pension or you’re years down the road, selecting and maintaining the right mix of investments is essential.
A misstep could mean less retirement income, running out of savings too quickly or more risk than you’re comfortable with.
In a typical situation, up to 60% of the money you withdraw from super during your retirement comes from investment earnings you receive after stopping work. Choosing your investments wisely can stretch each dollar you saved for retirement further.
Follow our guide, from working out the income you need to choosing and regularly reviewing the investments supporting your pension account.
Putting the income horse before the investment cart
Before you get into the nitty gritty of how to structure your retirement investment portfolio, you need to get a handle on how much income you will need to live on.
There’s no single answer to this question; everyone’s wants and needs are different. As a starting point, look at your current spending patterns and adjust for work expenses, mortgage payments, tax, voluntary super contributions and other items you hopefully won’t need to budget for in retirement.
Assyat David, founder of Aged Care Steps, suggests taking this process one step further by dividing your living expenses into two types of income:
- Essential income for food, electricity and other necessities
- Discretionary income for holidays, presents and non-essential spending.
This will help you structure your portfolio with the potential to provide different types of income from different types of investments.
Your income needs are also likely to change as you move through retirement. Spending is typically highest in the early active years, falls in the quieter years as people spend more time close to home, and can rise again in frail old age because of health and aged care costs.
Balancing growth potential and risk
When you’re no longer working or planning to step away soon, the knowledge that you won’t be earning income to add to your retirement savings if markets take a dip can be unsettling. You may be tempted to be more conservative with your super investments to protect your savings (and your sanity) from a crash.
However, market volatility is not the only risk that’s important to an investment decision. Retirees who flee too far towards the safety of defensive assets like cash and fixed interest are more exposed to the chance that their savings won’t grow enough to support their retirement income needs or to keep up with the increasing cost of living (inflation).
Including growth assets (shares, property and alternatives) in your investment portfolio improves your chances of better long-term returns, but increases volatility along the way.
The first step when choosing appropriate investments for your pension is to determine the level of risk that is appropriate for you, based on your timeframe for investing and how well you can tolerate volatility in your returns.
Different approaches to portfolio construction
From a portfolio construction perspective, Assyat David suggests two ways to think about providing the income you require through the various stages of retirement:
- An income-layering strategy
- A bucket strategy.
An income-layering strategy
To cover essential spending, you need a set amount of income from secure, guaranteed sources. This might include Age Pension payments, annuity-style products that pay a pre-determined income for life, and cash and term deposits. In other words, take a holistic approach and assess income from all sources, inside and outside super.
Discretionary income may then come from more risky investments held outside super, such as rental income from investment property and dividends from shares, or an account-based super pension. These assets may fluctuate in price due to market movements, but they also provide the potential for capital growth to cover your longer-term income needs.
How income layering matches spending to income
Based on the approach described by Assyat David, founder of Aged Care Steps
If you have a super pension, you could draw down income from the cash component of your account first and have the balance of your savings in a diversified portfolio. The bigger your super balance, the more you can allocate to growth assets once your income needs are secured.
David says this approach is not ‘set and forget’ but will need constant monitoring and adjustment as your circumstances and spending change in each of the three phases of retirement. For example, as you become less mobile you may cut back on discretionary income for travel, active leisure and yoga. Then in frail old age you may need to increase access to income for home care.
“This may require adjustments to drawdowns from your income stream products, management of term and lifetime annuities, and consideration of other strategies such as the potential capital drawdown in later years to fund changes to your home if you become less mobile,” says David.
A bucket strategy
A popular portfolio construction method used by many financial advisers is the bucket strategy. There are many variations, but typically it involves allocating funds to three buckets:
- The cash bucket supports two to three years of your retirement income needs with cash investments. This can be held within your super pension account. Then when you withdraw income you only draw from this cash portfolio. When the bucket is empty you top it up with income from the next bucket.
- The capital stable bucket holds conservative fixed interest investments but still has some exposure to growth.
- The growth bucket contains the rest of your money in a growth-oriented portfolio of shares, property and the like. The aim is not to touch this source of funds for maybe five years or more. If the market falls in the meantime, you avoid the problem of having to sell investments to support your income needs and crystallising your losses.
The idea is to provide long-term capital growth as a means of managing longevity risk, with enough cash and fixed interest investments to provide the retirement income you need in the short to medium term.
A fourth bucket for aged care
David suggests retirees also consider a fourth bucket to meet future aged care costs. “You could use this to pay for home care or you may need access to capital for home modifications,” she says.
You could invest in a product such as a deferred annuity that starts paying income at a specific age, say 85 or 90, when your super is timed to run out. That way, you don’t have to worry about living to a ripe old age and running out of money.
This is where your family home also comes into play as an integral part of your long-term strategy. For example, you could plan to downsize or release home equity using strategies such as the government’s Home Equity Access Scheme or a commercial reverse mortgage.
Product selection
After getting to grips with your risk profile, you should have a better understanding of the proportion of your savings you’re comfortable allocating to growth assets.
Before making final investment decisions, it’s important to consider the type(s) of pension you have chosen (or will choose) to invest your superannuation in.
Simple account-based pensions
The most common type of super pension held by Australians is a simple account-based pension. These accounts allow you to choose how your entire account balance is invested and which investments should be sold to provide for your pension payments (if you have selected more than one investment option).
If you will be using a simple account-based pension for all your super, you can choose a mix of investment options that will suit your risk profile and consider a bucket strategy to avoid selling growth assets to finance your withdrawals.
Lifetime pensions (other than defined benefits)
Another option is to use some of your super to purchase a lifetime pension. These products guarantee to provide income for life and can result in a higher rate of Age Pension, depending on your circumstances.
Some of these products are investment-linked, providing income that varies with the return of the underlying investments, while others have annual income payments indexed to increase with inflation. In an investment-linked product, you may have the option to choose an investment option, or there may be a single pool of assets managed by the provider with no room for individual choice.
Most investment-linked lifetime products don’t have an account balance. Instead, your chosen investment, or the return of the provider’s pool of assets, determines how your annual pension changes from one year to the next. However, there is at least one lifetime product available that is account-based, allowing you to see and invest your balance as you choose.
If you will be using a lifetime pension for part of your super savings, you should consider the assets it exposes you to when ensuring your overall allocation suits your risk profile.
Example: Partial allocation to CPI-linked lifetime pension
Dragan, aged 65, has $660,000 in super.
After considering his risk profile and goals, he feels an overall allocation of 60% growth assets and 40% defensive investments suits him.
Dragan has chosen to invest one-third of his savings ($220,000) into a lifetime pension that provides income indexed annually to CPI. This is considered a 100% defensive investment since income is guaranteed for life and will not fluctuate in response to movements in investment markets, but will simply increase annually in response to rising prices.
He will invest the remainder of his super in a simple account-based pension. To achieve his target asset allocation, Dragan calculates he needs to invest a total of $264,000 in defensive assets (40% x $660,000). That’s a further $44,000 on top of his lifetime pension. This means 10% of the $440,000 that will be placed in the account-based pension can be invested defensively and the remaining 90% can be allocated to growth assets.
Dragan’s asset allocation across his two pensions
Illustrative example
Example: Partial allocation to investment-linked lifetime pension
Melody, aged 70, has $400,000 in super.
After considering her risk profile and goals, she initially thinks an asset allocation of 50% growth and 50% defensive investments would suit her.
Melody chooses to invest half her savings in a lifetime super pension with pooled investments in a balanced portfolio of 70% growth and 30% defensive investments. The income from this product can go up or down from one year to the next, but is expected to increase in most years.
The remainder of her savings will be invested in a simple account-based pension. To achieve her target asset allocation, Melody would need to invest a total of $200,000 in defensive assets. Her lifetime pension has already allocated $60,000 (30% of $200,000), leaving $140,000 or 70% of her $200,000 investment to be allocated defensively in her account-based pension.
Melody selects her fund’s conservative investment option that has her required 70% defensive and 30% growth allocation.
When combined, her two pensions have a total asset allocation that matches her desired 50/50 split between growth and defensive investments.
Although the lifetime pension has a higher weighting to growth assets, there is no risk of Melody’s savings running out in that product because income is guaranteed to be paid for life. This additional security may offer the peace of mind she needs to be confident to reinvest her account-based pension with more growth assets in the future.
Melody’s asset allocation across her two pensions
Illustrative example
Defined benefit pensions
Some super funds pay a guaranteed pension for life instead of, or in addition to, an account balance at retirement. These defined benefit pensions are usually annually indexed to keep pace with inflation and often provide continuing income to a spouse after the member dies.
If you’re lucky enough to be entitled to a defined benefit pension, that benefit should be considered when you’re choosing a suitable asset allocation for any remaining savings you will be investing in super pensions.
What investment options do pension products offer?
After choosing the pension product(s) you will use and working out the appropriate asset allocation in any product you’ve selected that allows you to choose how your money is invested, the next step is selecting investment options from your fund’s menu that fit that allocation.
One factor when choosing investment options is deciding whether you would prefer an active or passive investment approach.
Active management means the fund’s investment managers choose investments based on their research and expertise. Indexed options, also known as passive investments, track the allocation of an underlying index, rather than only the investments that managers have selected. For example, the Australian shares portion of an indexed balanced fund may track the ASX 200.
Indexed options have lower investment fees than actively managed funds. Advocates for active management say that it can generate higher returns to compensate for the additional cost, but there’s not much evidence to support this claim.
Super funds generally offer three main types of investment options when you start a pension:
- Pre-mixed options
- Single sector options
- Direct investments.
If you want to choose indexed options, look for the keywords ‘indexed’ or ‘passive’ in the investment option’s name. Not all super funds offer indexed options in all the categories.
1. Pre-mixed options
Pre-mixed options are invested in a diversified combination of assets such as shares, property, infrastructure, fixed interest and cash.
These options are usually categorised by the proportion allocated to growth assets and labelled as High Growth, Growth, Balanced, Conservative or Capital Stable.
Your fund may also offer some pre-mixed options with a sustainable investment focus.
If you don’t choose an investment option (or options) for your pension, your fund will commonly use one of its actively managed pre-mixed options as the default.
2. Single sector options
These options reflect a single asset class such as Australian or international shares, global property, global fixed interest and cash. If your fund doesn’t offer indexed pre-mixed options, you may find they do provide indexed single-sector choices.
You can mix single-sector options together to reach your target asset allocation and choose which of them to withdraw your pension payments from.
It’s also common for retirees using a bucket strategy to choose a pre-mixed option for most of their account balance, but reserve some in the cash single sector option for their pension payments.
3. Direct investments
These investment options offer a selection of direct investments to choose from, including direct shares, exchange-traded funds (ETFs), term deposits and listed investment companies (LICs). If you owned direct investments through your super fund prior to retirement, you may be able to start your super pension without having to sell and repurchase your investments when you retire.
Direct investment options are generally only suitable if you have experience investing your own assets and want to spend the time required to successfully manage your own pension portfolio.
Regular review and rebalancing
Investing for retirement is not ‘set and forget’, particularly when you have chosen more than one investment option or retirement income product.
When you’ve got multiple investments, the weighting of each one will change over time as investment returns accumulate and you make withdrawals.
Your attitude to risk may also change as you age, and so does your timeframe for future investing.
Your spending will also change as you move through retirement, so any income layers or buckets you set up at the start will need adjusting over time.
Once your pension accounts are set up, take the time to review your strategy at least once a year and make any adjustments as needed.
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