Defending your pension income
When taking retirement income, there are very different financial considerations in comparison to saving towards it. When you’re drawing an income (your asset decumulation phase), market volatility can have much more significant effect than when you are saving. A new strategy must therefore be considered, but what can you actually do to defend your wealth and why might a new strategy be appropriate?
Cash isn’t always king
During periods of volatility you may be tempted to hold a large sum of retirement savings in cash. However, whilst cash should make up a proportion of a diversified portfolio, too much will leave you exposed to the effects of inflation in the long-term.
While the base interest rate currently remains low at 0.75% and inflation has been between 2 and 2.7% throughout 2018. The buying power of cash is effectively eroded over time. Furthermore, any increase in the rate of inflation will only exacerbate the problem. Research from Schroders shows that after adjusting for the effects of inflation;
- £1,000 hidden under the mattress at the start of 1989 would now be worth £467 due to the effects of inflation, an annual growth of -2.7%
- £1,000 left alone in a UK savings account at the start of 1989 would now be worth £1,011, an annual growth of 0.03%
- £1,000 invested in the FTSE All-Share index at the start of 1989, with all income reinvested, would now be worth £5,683, an annual growth of 11.2%
When planning towards a long-term goal such as retirement, having a diversified portfolio of investments should provide growth at least outstripping inflation, and when properly managed, far exceeding it. As is often the case, the higher the risk you take on, the higher the potential reward. Naturally, we are here to ensure your asset allocation remains aligned with your attitude towards investment risk and capacity for loss at all times.
Pound cost averaging during whilst saving (your asset accumulation phase) means that making regular pension contributions helps smooth out volatility. In essence if the markets fall you benefit from buying more stock or fund units whilst it is cheaper and look to sell when it is higher. However, selling stock or funds to provide for a fixed income during your spending/decumulation phase, no matter the performance of the underlying investments , can erode your pension value significantly.
This is a real concern for retirees and we believe that this will be felt by more and more of the population now that annuities have fallen out of favour as it increases longevity risk – the risk of outliving one’s savings. If not managed properly it may lead to dramatically different retirement outcomes even if two investors are exposed to the same average return. The timing of positive and negative returns makes a significant difference to the success of otherwise of your financial plans. Known as sequencing risk, this is especially the case if you experience volatility at the very beginning of or just before retirement, whilst you pension value is highest as illustrated below.
Research from Doran, Drew & Walk (2012) determined that “…a poorly timed negative return event (of around -20 per cent) can raise the probability of ruin from 33 per cent to 50 per cent”. At HFMC Wealth we take this incredibly seriously and it is one of the reasons we look to monitor and manage volatility within portfolios, and look to manage and agree withdrawal strategies with you that will apply equally through different market conditions. Retirees can hope to retire when markets are rising, but hope is not a strategy to a successful retirement. We can never know when retiring if we will have a sustained bull market after retiring or a crash like 2008.
There are a number of planning strategies we combine and recommend to combat against this:
- Plan ahead and minimise downside risk:
We know that sequencing risk increases when there is more capital at risk, such as when you approach retirement as an investment loss occurring when your nest egg is large will have a disproportionate impact on how long your savings will last. Again studies show that the risk is from 15 years prior to retirement to about 10 years after you retire. For our clients, this is one of the key reasons that we are more focussed on active funds – to be able to proactively manage the risks of a falling market and dampen the impact of a market fall more than a passive investment would.
- Remain invested:
First and foremost, your portfolio is still required to provide investment returns above the rate of inflation. You are more likely to achieve this by remaining invested in a suitability diversified portfolio and remembering that periods of volatility are the price you pay for ‘real returns’ in the longer term.
- Regularly review your pension and mitigate risk:
Your portfolio should be reviewed at least annually, to assess your own spending patterns and needs. We are continually reviewing our discretionary portfolios from an investment perspective. This helps identify any market opportunities or threats as quickly as possible and consider whether it is appropriate to take action.It is important to consider that when reviewing investment performance regularly, volatility is inevitable. Rash decisions shouldn’t be made in light of a temporary downturn, especially when the ultimate goal is long-term.
- Preserve your retirement capital:
Taking a sustainable level of income is key. Reacting to volatility by withdrawing less from your pension or taking it from a different source such as cash assets, will help preserve retirement wealth.By using cash flow planning we are able to examine the impacts of market shocks on your plans, helping you to understand what is affordable within your own retirement whilst giving consideration to your financial position should you live well into your 80s, 90s or beyond.Worryingly, a study from Zurich found that 49% of people drawing an income from their pension said they would continue to withdraw the same amount, even in the event of a market correction. Only 12% had the foresight to either scale back their level of income, or to plan ahead and agree withdrawal levels that take into account the likelihood of experiencing both rising and falling markets. We would suggest that our clients fall into the latter category.Furthermore, 36% of people who remain invested during retirement do not have a cash reserve to rely on during volatility. Of the 64% that do, fewer than one in 10 would think to utilise it for income withdrawals during significant volatility. If you are ever concerned about the level of income you are taking from a particular asset, we are only a phone call or email away.
- Plan where to draw your income or capital from:
With planning we are able to structure your retirement “pots” to use more of your available tax allowances. There are a number of investment vehicles that allow us to use Capital Gains Tax allowances, personal allowances, or provide tax-free income streams. Of course we can all understand that you need to withdraw more from an investment that you need to pay tax on than if you withdraw from a tax-free investments to end up with the same amount of money after tax. We can help you structure your investments to maximise your net of tax returns in retirement if given the time to plan – it can take years to structure and implement the optimal strategy for the future as many types of plan have maximum funding allowances each year, such as ISAs.
- Consider an annuity:
Historically low interest rates and greater flexibility in the way you can withdraw your pension has meant that Annuities are no longer as prevalent. But, with recent volatility and the uncertainty of Brexit, they have made a resurgence.
Although returns are not as generous as we’ve seen in the past, a guaranteed, inflation liked income offers a risk-free component of a hybrid retirement strategy, something to consider as healthcare continues to develop, allowing more of us to live longer.
Consider your longevity
It’s surprisingly common to underestimate your lifespan. You’ll either fall short of income in later life or eat into the legacy earmarked for loved ones. Research from the Institute of Fiscal Studies found that Men in their 50s and 60s think they have a 65% chance of reaching 75, whilst the official estimate is actually 83%. Women in the same age bracket also believe they have a 65%, the reality is an 89% chance of living until 75.
According to the Office of National Statistics, a 65-year-old man can expect to live a further 18.6 years, on average, and a female 20.9. We would reasonably expect the lifespans of our clients to be greater than this though as our clients are not average – many have access to private healthcare and we have benefitted from good diets, exercise and live in less polluted areas. Your health naturally has a large impact on these figures, but as a population we are living longer, unhealthier lives, against a backdrop of health improvements that keep us alive longer, even if it isn’t with the same quality of life. That could result in additional care costs when you want to be preserving wealth for future generations.
Advice is invaluable
Retirees are a special class of investors who typically either do not have much time before they retire or who are constantly drawing down on savings. Retirees are highly sensitive to sequencing risk which peaks in the years shortly before and after actual retirement when retirement savings are at their highest. Advice as to how to address sequencing risk should ideally be addressed early as part of a transition strategy before retirement.
You might not have the time or inclination to consider all these points. Frankly, you don’t have to. If you are nearing or in retirement and would like assistance planning your income strategy, we are here to help. Our aim is to achieve a prudent balance of investment performance through thinking long term, looking to minimise exposure to volatility where we can, keeping it simple and aligning your desired investor outcomes with your risk/reward profile derived from our financial planning process.