The impact of stock market volatility on retirement benefits

The Australian Stock Exchange has been volatile in recent weeks, following crashes in the US and Chinese markets.

Shocks in the market such as these can have a significant impact on the superannuation savings of Australians.

At June 2013, 51 per cent of assets in the default option in superannuation funds were held in equities, and thus exposed to market volatility. The risk from stock market volatility is borne by members of superannuation funds, and it is suggested the majority of those members have little idea of the potential impact of this volatility on their retirement planning.

Not only will normal volatility of the stock markets impact retirement planning, but major shocks to the markets can be catastrophic if they occur at the wrong time. There have been seven of these major market shocks between 1970 and 2010:

Stock market falls of 20 per cent to 40 per cent are not that uncommon, and depending on the timing of the shock, they can have major impacts on expected retirement benefits.

In a paper recently published, with my co-author Amanda Ganegoda, we estimated the impact of market shocks and other factors on retirement benefits for a typical single retiree and a couple. For a full description of the assumptions we made readers are referred to the paper, but the essential characteristics we took into account were that the retirees were members of a fund with Superannuation Guarantee Levy (SGL) contributions of 12 per cent per annum over 42 years and the retirees earned average weekly earnings over that period adjusted for inflation and productivity increases.

We assumed that the basis of taxation would not change. We also took into account periods of non-participation in the workforce. We used the asset allocation for some typical investment options and assumed they remained constant, as well as simulating normal returns on these assets using models built from data over the 40 years to 2010.

Market shocks based on the historical data shown previously were then randomly introduced to the model. We took into account eligibility for the Age Pension assuming the current rules remained applicable.

Allowing for different numbers of market shocks and assuming an asset allocation for the typical balanced option which is reasonably close to the 51 per cent allocation to stock markets at June 2013, the following table shows for the married couple and single male, the replacement ratio distribution that emerged. The replacement ratio is the ratio of net income post retirement to net income pre-retirement; it is generally accepted that a ratio of around 60 per cent is desirable for a comparable standard of living pre and post retirement.

The distributions of the replacement ratios is indicative of what could occur over time, such as what different cohorts of retirees could receive, and indicates that based on the assumptions made, the replacement ratio for some cohorts of retirees could be as low as 40 per cent, and for others, as high as more than 400 per cent.

The shaded results indicate where the replacement rate is below the acceptable level of 60 per cent. One of the striking results is that it appears that retirees only have a reasonable chance of achieving the 60 per cent replacement ratio (or better) if there are no shocks to the stock markets, but once you bring into account market shocks, the replacement ratios decline rapidly. Of course the results also show that a few cohorts of retirees, even with market shocks will have a better standard of living in retirement than before retirement based on being very lucky with favourable investment returns during their working life.

We did test alternative investment strategies based on the typical diversified investment options offered to members of superannuation funds, but the results were not all that different to those from assuming investments were held in “balanced” options.

The consequence of these results is that retirees cannot assume that long term projections, usually based on very simplistic on average assumptions as to their retirement benefits will be remotely correct.

Retirees should also not then assume a fixed retirement date can be implemented as market shocks occurring in the last decade prior to retirement will have major effects on the adequacy of their retirement benefit.

If retirees suffer a lengthy period out of the workforce just prior to retirement, and significant market shocks occur, then their retirement benefit will predominately come from the Age Pension, with little enhancement from the SGL system.