Let's take a baseline retiree as an example – An 70 to 80-year-old Australian couple with $1m to live off in a house with no mortgage in a zero tax environment.

They hold the classic Australian equities portfolio that averages out to a yield of around 4.5% plus average market franking (about 72%) taking it up to 5.89%. They have instructed all the companies they own to pay their dividends into a specific bank account, and they live off that bank account, about $45,000 a year plus an annual ATO cheque for somewhere between $10,000 to $15,000 depending on the franking. They have mostly banks, Telstra and hybrids. They are hopeful the bank sector will come right, and that they will “be alright in the end”.

For this couple, there are several issues that they probably share with a lot of retiree investors who are focused on income:

• They have lost trust in advice, especially after all that Royal Commission stuff. They feel that they are ‘on their own’ and everyone in the finance industry is a predator.
• Their focus is on the bank account that the dividends get paid into. This determines whether they feel ‘poor’ or ‘rich’. They have sort of lost sight of the ‘capital’ and whether it’s going up or down. The income from their shares dominates the mood because that’s what they live on, and their sole focus is that the income doesn’t go down.
• They have to budget for the months when no dividends come in. Stocks only pay twice a year. Thankfully for them, the CBA and Telstra dividends are three months out of sync with the ANZ, Westpac and NAB, so they get income every three months. But still it’s not regular income, dividend cheques arrive in lumps which means they are sometimes hanging out for dividends to arrive before they can pay some annual bills.
• Because the franking can take up to eighteen months to arrive they only really budget to live off the dividends as they arrive. The franking credit refund, which arrives in one big ATO cheque, after they put in our tax return, is not part of the living expenses budget because they use it to cover one-off items like holidays, cars, the bathroom renovation. They thank the Lord on a daily basis that Bill Shorten didn’t get in and get rid of this refund.
• They don’t enjoy worrying about the equity market, it’s more stress than pleasure, especially when they are not experienced, confident, IT savvy and are losing their marbles. They don’t want to pick stocks and trade. But they are still exposed to it, and they invest with their fingers crossed behind their backs.
• They can’t afford another once in a lifetime stock market event like the GFC. Another GFC now would be like that meteor was to the Dinosaurs and if it happens again they don’t have a fallback, they just assume, hope, it won’t happen. They cannot afford to have the equity market fall, not on $45,000 a year, but still they remain exposed because of the dividends and that franking credit refund. They have to preserve capital but they still have money at risk.
• Inflation is an issue. They know the RBA says its less than 2% in the official figures, but the Australian Bureau of Statistics obviously don’t eat anything, insure anything, have utility bills, drink coffee or drive anywhere. And they obviously don’t have to buy birthday presents for twenty grandchildren or be the bank of last resort for the financial failures of their kids. ‘Real’ prices are going up and they are irritated by a government that pretends they aren’t.
• They aren’t big spenders but on a bit more than $45,000 a year, they are cutting into their capital each year and can afford less and less not more and more.
• All in all they feel poor and with ‘real’ inflation included their standard of living is going backwards, and after a lifetime of work, it seems unfair that being a millionaire means being poor.

OK - There are a few things going on here, a few assumptions being made that are incorrect and the most obvious one is this. The assumption that a millionaire will be able to live off the income they earn on their capital is no longer true. The decades of 5-10% risk-free returns are over.

Happiness is all about expectations and if happiness in retirement is income expectations met then the guaranteed way to be happy is to have very low income expectations. So lets set some realistic, zero interest rate environment expectations, expectations that you will not find the average financial planner preaching to their clients yet, but should. For instance:

• Assume interest rates are going to zero, Philip Lowe is trying to prepare us for that.
• Assume that bonds and other risk-free investments are going to yield next to nothing. They already do.
• Assume that inflation in retirement is higher than the risk-free return (we now have the first negative ‘real’ risk- free return in decades).
• Assume that the banks are going to cut their dividends and franking. The ANZ just did.
• Assume that the stock market return is not reliable in your timeframe.
• Assume you want to stay in your big house.

Now what are you going to do, because as the real risk-free returns tend to zero, the dollar threshold at which you can consider yourself “wealthy” and able to retire is rapidly rising as interest rates and reliable income sources fall. Arguably there are going to be no risk-free returns before long, and that means you will need a lot more capital to retire.

So what do you do?

The most obvious thing is that retirees are being pushed into the equity market looking for a yield and in so doing are putting their capital at risk, possibly at just the wrong time, when the equity markets are pumped up on money printing, are at the mercy of the new ‘Trump Tweet volatility’, and just as the yield curve inverts suggesting heightened recession risk.

What needs to happen is that the mindset of not just retirees, but the whole financial advice industry, starts to question their history-based, blasé optimism, that promises clients the old risk-free returns of 5-10%. The risk-free return is going to zero which means that 5% is now a 'risk-return' not a risk-free return.

There was an article in the financial review recently entitled “Brace for 5% super fund returns” which suggests that superannuation funds should consider downgrading their “promise” to members to reflect the likelihood that they are going to get lower returns. It says “For the past decade retirees over 65 have been fortunate enough to be able to draw the government-mandated minimum amount of 5 per cent from super yet keep saving because they were earning 7 per cent. As a result many people in their mid-70s now had more money than when they retired. That is unlikely to be the case for those retiring today, and Super fund communications, including retirement calculators, need to show the impact of potentially worse outcomes relative to the past. Consequently, more members will need to draw down their capital earlier.”

Bottom Line: The financial advice industry needs to take negative real risk-free returns on board and start putting together financial plans that include spending capital because the income is almost certainly going to dwindle, possibly to zero. We need to kick clients out of the fantasy that they are going to be able to live risk-free off income alone and still grow their nest egg every year after expenses. We need to put 'making and spending capital' into our spreadsheets and inform our clients that their ingrate children are going to have to make their own money.

My next-door neighbours, an old couple, lived in abject poverty. When finally they both died within a year of each other, the For Sale sign went up on their house and their wealthy daughter pocketed $999,000. Depending on where your finances are, leaving your share portfolio and your house to your children may be a luxury you can’t afford. I have a name for a financial plan in the zero interest rate environment, a name that encapsulates spending capital as well as earning income - it is called the “Penniless at 100” plan because unless our clients are really wealthy, that’s what they are going to be.

Footnotes:

• Expect a boom in one level half block no garden houses for downsizing retirees.
• Pre-retirees need to start saving and stop spending because they are going to need a lot more than their parents to retire.
• Any fund managers that can reliably achieve capital growth in a zero interest rate environment will attract billions.
• Reliable 5-10% earnings growth stocks with high payout ratios will become the new ‘sexy’ in the equity market.
• Get rid of that spare room, or your kids are never going to leave.

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Marcus Padley is the author of the Marcus Today stock market newsletter. To sign up for a 14-day free trial please click here.