Investment /asset strategy for retired couple: too skewed towards equities?

[Protocol]

Ages: both 65+

Incomes = Work pension + AVC / ARF pension income + State Pension + wages [small] + self-employment [small]

Gross income = 49k approx., made up of five incomes, mainly work pension = 35k approx


Assets

(1) House PPR = 250k

(2) Managed funds – 100k original investment across eight funds, 12.5k per fund, a mixture of bond funds, equity funds and property funds

The overall value has dropped as low as 85k, but now at 125k. The bond funds have done very well lately, but the property funds have not.

(3) AVC / ARF fund = 70k approx., with a 5% annual income drawdown. Since retirement, maybe 4 years ago, this fund has held steady, even with the 3/4/5% income withdrawals

Half of the ARF fund is in the Irish Life Consensus Fund, I think.


(4) An Post Savings Certs = 150k

(5) Other deposits = maybe 50k, max 100k


Although their income is steady, I am a bit worried that my parent’s assets are too skewed towards equities for people their age, approx. 68-70

They have nearly 200k current market value in managed funds / ARF funds, compared to approx. 200k on deposit.

They haven’t a clue about equities/funds

I would welcome any comments on their asset mix / financial planning.

 

[Steven Barrett]

There is no one size fits all answer to this. Everyone is different based on their needs, goals and how much loss they are able to absorb.

1. What are your parents trying to achieve?
2. What are the managed funds for? Do they intend to spend the money anytime soon?
3. With their ARF, do they want to maintain its value or are they happy to run it down over the next decade or so?
4. Would a fall of 30% of their Managed fund and AVC have a serious impact on their lifestyle?

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

 

[Brendan Burgess]

Hi Protocol

I have done a Key Post which addresses these issues:

"I am 65 – where should I invest my life savings? "

In this couple's case, they have no mortgage or rental costs.
They have an income of €49k which is probably adequate for them.

They have other assets of around €350k (excluding the ARF which seems to included in their income?)

So in total, they have assets of €600k and a pension of €49k

They face three big risks - longevity, ill health, and the solvency of the Irish state.

They can probably expect to live for another 20 years, so they have a very long term investment horizon.

The correct place for them to have their money is in equities.

It's too risky having money on deposit, especially in An Post, as there is a considerable risk over the next 20 years that the Irish state will become insolvent. Given that some of their pension is also coming from the Irish state, they should diversify away from it.

They should hold shares directly rather than in managed funds as it's quite likely that they will still have them on their death. If so the gains won't be subject to CGT. Gains in the fund will be subject to exit tax at 41%.

I would put all the money into a portfolio of 10 blue chip shares, 5 in his name and 5 in her name. When the first person dies, the other will inherit the lot free of CGT.

 

[Sarenco]

Hi Protocol

Brendan has been consistent in his view that a portfolio of 10 large cap shares provides sufficient diversification in terms of equity investments. However, I think it's fair to say that this is a controversial position and is certainly not a view I would share.

I do, however, agree with Brendan that the taxation of Irish investment funds (outside pension wrappers) is now at a point that they really do not make sense for most Irish investors (as an aside, I suspect this is part of a deliberate government policy to make (direct) property investment relatively more attractive).

It seems to me that the solvency of the occupational pension scheme(s) is actually the biggest financial risk facing your parents, followed by their exposure to the Irish State.

If I was in their position, I would do the following:

1. I would ensure that their ARF was invested 100 per cent in an international equity fund (no allocation to fixed income within this account) and would draw down at no more than 4 per cent per annum (the minimum required drawdown);

2. I would gradually liquidate the managed funds over time;

3. I would allow the State Savings Certs to mature;

4. I would invest a chunk of the proceeds of 2 and 3 above in home improvements designed to improve their PPR's BER as far as practical and would ensure that all insurances (particularly health insurance) are in order; and

5. I would deposit the balance in savings accounts and term deposits of Irish branches of non-Irish banks (Rabo, Investec, Nationwide UK), making sure to stay below the respective government guaranteed amount per depositor, per institution.

Many would consider this an overly conservative allocation but your parents would still have a significant portion of their net worth allocated to equities and would significantly diversify away their exposure to the Irish State. Their occupational pensions are obviously significant and assuming these include a provision to increase with inflation, I wouldn't personally consider it necessary to adopt an aggressive allocation for their age, particularly as they own their PPR mortgage-free and have adequate pension income. Others may disagree!

 

[Brendan Burgess]

It seems to me that the solvency of the occupational pension scheme(s) is actually the biggest financial risk facing your parents,

Interesting point. Only if it's an underfunded defined benefit pension scheme. But it's a risk which they can do nothing at all about, although it might affect how they invest the remainder of their assets.

5. I would deposit the balance in savings accounts and term deposits of Irish branches of non-Irish banks (Rabo, Investec, Nationwide UK), making sure to stay below the respective government guaranteed amount per depositor, per institution.

I just consider that deposits are way too risky. People find it hard to see that, but three things can go wrong. I don't expect any of them to go wrong, but they are more likely to occur than a sustained long term fall in equities.

1. Ireland leaves the euro - so your deposits could overnight lose a large part of their value
   
2. Inflation erodes the value over the longer term
   
3. The banks or their guarantor, the Irish government, go bust.

I wouldn't personally consider it necessary to adopt an aggressive allocation for their age, particularly as they own their PPR mortgage-free and have adequate pension income.

I would argue that because they have adequate pension income and own their own home, they can handle the volatility of the stockmarket.

But, in any event, I reckon that the stockmarket is a lot less risky than deposits.

 

[Sarenco]

As Steven points out, there is no one size fits all answer to this but I think it's worth exploring some different perspectives.

I assumed from Protocol's reference to a specific annual payment amount of €35,000 that the pension was a final salary, DB type scheme that is currently in payment but perhaps Protocol could clarify.

I certainly agree that a pensioner can do very little to mitigate the risk that an occupational pension scheme may be, or become, underfunded to an extent that it is unable to meet its promises (in part or in full) to its members. However, it seems to me that the extent to which Protocol's parents are reliant on this occupational pension to fund their living expenses substantially reduces their ability to take investment risk with their other assets, whatever about their need or willingness to do so. As such, I would have thought that a relatively conservative asset allocation would be appropriate. This is obviously a matter of opinion and I am only suggesting what I would do in their situation. I’m sure others would come to a completely different conclusion depending on their individual risk appetite - whatever lets you sleep at night!

Taking Brendan’s points on the risks of deposits in turn:

1. Currency risk is obviously a two way street – the currency in which the deposits are denominated (or redenominated) could just as easily appreciate as depreciate as against other currencies. In any event, currency risk also applies to equities.

2. Inflation reduces the real return of all income producing assets (equities, fixed-income and real estate) and there is nothing unique about deposits in this regard. Currently most term deposit rates in Ireland are comfortably ahead of inflation (whether expressed using CPI or HCPI) – even after DIRT. Conversely, history does not indicate that the return on equities will necessarily outstrip inflation over the likely investment period (for example, the Dow Jones industrial average famously lost 90% of its value between 1929 and 1932 and took over 25 years to reach its previous high).

3. I suggested depositing the excess funds in institutions that are covered by the guarantee schemes of the Dutch and UK governments, respectively, in order to remove the default risk of the Irish government entirely.

I do not want to give the impression that I think it is inappropriate for a retiree to have any equity exposure whatsoever (I suggested that the ARF should be held 100% in an international equity fund and should be drawn down as slowly as possible in order to maintain this allocation). I would agree that it is important that some allocation to equities be maintained as a long-term hedge against inflation.

However, there have been decades (e.g. 1930s, 1970s and 2000s) where fixed-income investments have outperformed equities. In fact, in the 30-year period ended September 2011, 20-year treasury bonds actually outperformed the S&P500. The fact that equities have historically always out-performed fixed-income investments over long time periods will be of little comfort to Protocol's parents if they need to access funds at a point in time when their equity holdings have suffered a serious decline in value. If they have to sell equities at that time to fund their living expenses they will be locking-in their losses permanently.

Currently, it seems to me that term deposits represent the best fixed-income investments available to Irish investors, on a risk-adjusted basis. For example, Nationwide UK is currently offering a two-year term deposit at a rate of 2.1% that is fully guaranteed by the UK government to a limit of £85,000 (approx. €108,600) per depositor whereas a two-year gilt (which has the same duration and default risk) is currently yielding 0.42% (and you would also have to deduct transaction/holding costs from this yield whereas there are no such costs applicable to deposits).

 

[Brendan Burgess]

However, it seems to me that the extent to which Protocol's parents are reliant on this occupational pension to fund their living expenses substantially reduces their ability to take investment risk with their other assets, whatever about their need or willingness to do so.

But you are assuming that deposits are less risky than equities. I would say, that if they have an exposure to an underfunded DB fund, they cannot afford the risk of deposits.

I did a separate Key Post on the issue here:
State savings and deposits in irish banks are not risk-free

1. Currency risk is obviously a two way street – the currency in which the deposits are denominated (or redenominated) could just as easily appreciate as depreciate as against other currencies.

Yes, but if the Euro breaks up, I would guess that there could be a significant devaluation of Irish Euros.

In any event, currency risk also applies to equities.

Yes, but a diversified portfolio of equities, will be exposed to companies whose earnings are in a mix of currencies.

2. Inflation reduces the real return of all income producing assets (equities, fixed-income and real estate) and there is nothing unique about deposits in this regard.

That is a good point which is often missed. Maybe the argument should be reframed: "The long term returns from equities is likely to be higher than from deposits. Equities are likely to grow in real terms. Deposits are likely to fall in real terms".

Both equities and deposits are affected by inflation. The question to ask is which is more likely to beat inflation.

 

[Protocol]

Some more details

Work pension is a public service DB pension = 35k approx
AVC/ARF fund is worth 70k approx, which with a 5% annual income drawdown means 3.5k income
Other pension is a State Pension = 6k
Other income is wages/profits of 5k approx

 

[Protocol]

There is no one size fits all answer to this. Everyone is different based on their needs, goals and how much loss they are able to absorb.

1. What are your parents trying to achieve?
2. What are the managed funds for? Do they intend to spend the money anytime soon?
3. With their ARF, do they want to maintain its value or are they happy to run it down over the next decade or so?
4. Would a fall of 30% of their Managed fund and AVC have a serious impact on their lifestyle?

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

1. I suppose you would call them risk-adverse, they want to protect their savings

2. There is no defined purpose for the managed funds - they don't really know that they own them. They are old life savings policies encashed and merged into a 100k managed fund.

No, they do not intend to spend the managed funds soon. They aren't really aware that they own them.

They can't spend their income, they save out of their income, so their is no question of the managed funds being spent anytime soon.

3. They don't need the 5% income, 3.5k, they just draw it down for tax purposes.

4. No. That has happened. They didn't know about it, and it didn't impact them one iota.

 

[Marc]

Some initial observations and planning questions to consider.

1) The average life expectancy of a 70 year old in Ireland today is 85.5.

This means that on average at least one of the couple should be expected to live at least another 15 years.

2) Assuming an average annual inflation rate of 3%pa ( which is about right historically) the value of their wealth in today's terms will probably fall by about 1/3rd over the next 15 years. It could be much worse than this, but it would be imprudent to expect a much better outcome.

With a rate of tax applicable to investment deposits/ funds of currently 41%, just to stand still they would need to earn a gross return of something like 5.08% (I haven't done this calculation exactly correctly but it's close enough for illustrative purposes)

But, you really need to ask the question why is "standing still so important?" it's not like they have the perfect, optimum amount of wealth today and any less will hurt them so profoundly that they have no alternative but to pile into equities.

If their goal is to have the best chance of having the most money in 15 years time then yes equities are the way forward. But then who are they really investing for? Themselves during their lifetime or their children after their lifetime?

If they don't need the money, then they should consider giving it away now. The point is that they probably don't know for certain that they wont need some or maybe all of the money in the future. For example,

3)In the USA 5% of Medicare patients die each year but spend 30% of the total budget. The point being that the last few years of someone's life can be staggeringly expensive.

So, that's at least 15 years of uncertainty and the potential for a large medical/nursing care bill at the end of it.

4)The estate is worth at least €670,000 and yet no one has mentioned estate planning. How many children are there? Is CAT a problem?

What about a power of Attorney so that if they lose mental capacity their needs can still be taken care of?

Until all of these questions and issues ( and more besides) are considered fully nobody should be shouting out recommendations to invest anything anywhere.

An investment portfolio without a structured plan is just a wing and a prayer.

 

[Steven Barrett]

1. I suppose you would call them risk-adverse, they want to protect their savings

2. There is no defined purpose for the managed funds - they don't really know that they own them. They are old life savings policies encashed and merged into a 100k managed fund.

No, they do not intend to spend the managed funds soon. They aren't really aware that they own them.

They can't spend their income, they save out of their income, so their is no question of the managed funds being spent anytime soon.

3. They don't need the 5% income, 3.5k, they just draw it down for tax purposes.

4. No. That has happened. They didn't know about it, and it didn't impact them one iota.

I would echo a lot of what Marc said, they need a structure. Their day to day living expenses seem to be covered by their pensions but what do theu want to do with the rest?

For example, they don't really know they have €100k in investments. What if I said to them, "Say I give you €100,000 in cash for you to do whatever you want with it, what would you spend it on?" Would they go on a cruise, pay for their grandkids (if they have any) college fund, go on 4 holidays a year for a few years.

There's no point in saving money if you have nothing to spend it on in the future.

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)