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Income matters as much for SMSFs as it does for businesses

by Craig Swanger | Dec 02, 2014

In the 1930s, the average Australian worked from 16 to 65, or for 49 years, but life expectancy was only 63 years.  That is, the average person could spend 100% of their income as they earned it, not needing to worry about funding their retirement years. 

By the 1970s, we started work a bit later at 20 and retired at 62, with a life expectancy of 71.  That is, we worked 42 years and had an average of nine years in retirement.  Each year of work needed to additionally pay for three months in retirement.    

Now we work from 23 on average, and retire at 58, with life expectancy of 82.  We work for 35 years and on average are retired for 24 years.  Each year of work now needs to additionally pay for eight months in retirement. 

If our working lives were run as a business, we’d call this having to lower our “cost-to-income” ratio – we have to spend less of our income during our working lives every generation because we are living longer:

  • The Australian expecting to retire in the 1930s could have a cost-to-income ratio of 100% on average.
  • The 1970s retiree could have had a cost-to-income ratio of about 80%, saving around 20% of their annual income to have enough to fund their retirement years.
  • The 2010s retiree needs to have a cost-to-income ratio of about 33% or saving a massive 67% of their annual income to fund their expected retirement years.

Of course these are just the average life expectancies.  Anyone expecting/hoping to outlive the average needs to save more than these ratios. 

The simple analogy above ignores the fact we typically earn more in the later years of our careers and the benefits of compounding investment returns on those savings, however the clear indication is that we need to save more over a shorter working career for a longer retirement.

Managing your SMSF like a business

Managing your SMSF is no different to managing a business – the golden rule is don’t run out of money.  Particularly once retired and you have no other source of income, you need to:

  1. earn enough income to fund the lifestyle you’d like;
  2. without blowing up the business (your capital); or
  3. try to cut costs. 

The biggest difference is that in business you can sometimes raise more money.  Once you retire, you have a finite amount of wealth to fund your retirement years, so the risks of getting it wrong are higher. 

Because of the dramatic consequences of getting it wrong, once retired in particular you should increase income to a point that helps you fund your lifestyle but no further. 

Similarly, again like in business, earning too little income will result in “going out of business”, in this case running out of money before you can afford to. 

In today’s environment where cash deposit rates are at historic lows, and not expected to rise in the foreseeable future, allocating too much to cash is actually one of the riskiest investment strategies. 

Warren Buffett made this point: “The asset class that most investors consider the “safest”—cash—is actually extremely risky.”  This ‘zero-risk’ strategy will steadily erode the value of the nest egg over the retiree’s life even with very modest withdrawals.

On the other hand, an equity-only portfolio has high expected returns, but comes with more and more short-term volatility as the world recovers from the GFC. 

Given this conflict between the need for safety and the need for growth, it’s no wonder retirees around the world use bonds to increase their income.  Bonds are the middle ground between cash and equities – they offer greater security than equities, while offering more income than cash.

Note that this doesn’t mean selling out of the companies you have held for years.  Australian investors often have the choice of holding many ASX companies as either equities or bonds.  See the article in this week’s The Wire: “Investing for yield: When to pick the equities and when to pick the bonds”, for more about how to create a high income portfolio by combining equities and bonds. 

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