Did you know that with increased life expectancy, retirement can last 20-30 years or even longer?
While reaching retirement is a significant accomplishment, it’s important to have a plan to make your savings last. This article will explore the key challenges of retirement income planning and how to navigate them effectively.
What are your key retirement risks?
Throughout your working life, you have become used to receiving a regular income and have probably been saving with retirement in mind. Now that day has arrived and the income has stopped, will your ‘nest-egg’ savings be enough to fund your lifestyle and enjoy your newly found freedom?
So, what changes in retirement?
Less earning flexibility
Once you retire, your income has usually peaked. And with no other income beyond the assets, you’ve built-up, it’s important to take less risk with what you have.
Inflation reduces your spending power
A major challenge is preventing inflation from depleting the buying power of your income through decades of retirement. For instance, a yearly income of £10,000 in 1990 had the buying power of £4,760 by the end of 2020 – a reduction of over 50% (based on using the Consumer Price Index (CPI).
You might live for decades!
A healthy adult in the UK born around 1960 has a 10-15% chance of living to be a hundred. This poses a different kind of challenge; how do you ensure your retirement pot will last for the rest of your life? Especially when you don’t know how long you’ll live.
A robust withdrawal plan helps to ensure you’ve got money right through to those twilight years. We can’t predict how long you will live but we can mitigate the risk that you outlive your money.
Sequence risk
A big market downturn early in retirement could significantly affect your nest egg.
Capital markets deliver good returns over the long term, but when you start withdrawing from your investments, it becomes trickier to maintain those returns. And where you are right now, at the start of your retirement journey, sequence risk is the biggest problem you face.
The best way to mitigate all of the above risks is to approach them in a scientific way. And that’s where a financial planner comes into their own.
A note on sequence risk
What is sequence risk?
Put simply, it’s the risk of receiving unfavourable returns from your portfolio, caused by withdrawing money from your assets. For example, if you had to withdraw some money from your portfolio at the same time as a market downturn.
When is the danger of sequence risk at its highest?
The first years of your retirement is when sequence risk can bite the hardest.
Research shows that returns during this period will have a disproportionate effect on your overall financial outlook.
Get good returns in those early years, and you’re unlikely to run out of money. Get poor or even mediocre returns early on, then you may have a problem.
Is sequence risk related to market volatility?
No, they are different things, though they are often confused. Volatility is the day-to-day movement in your portfolio. Sequence risk, on the other hand, relates to the order of portfolio returns.
A good financial planner will help you contend with volatility, but they will also protect you from the dangers posed by sequence risk.
With so many factors in play, what’s the best way to plan your retirement income?
This is a question that has challenged financial experts throughout the modern era. Noted economist and Nobel Laurette William Sharpe calls it the ‘nastiest, hardest problem in finance.’
Using historical data is the gold standard
In recent decades, financial planners have turned to the wealth of historical data we have available about market conditions over the last century. Noted US financial adviser Bill Bengen proposed modelling a retirement fund through the turbulent market conditions of the 1900s, to find what is known as a ‘Sustainable Withdrawal Rate (SWR)’. This figure, when adjusted for inflation, can be withdrawn from your retirement fund each year, and give you an income that will last for decades.
This method has become known as the 4% rule.
THE 4% RULE IN PRACTICE.
If you had £1 million pounds worth of investments in your retirement pot, you could withdraw 4% of that money, which is £40k, in the first year. In the following years, you take out the same amount, adjusted for inflation. In theory, this would offer you strong reassurance that you will have enough money to last for thirty years, regardless of the changes to your portfolio value as time goes on.
Sounds easy, right? Well, as it happens, the 4% rule is a far from perfect…
The 4% rule isn’t the full story
While Bengen’s ideas are useful, simply applying the 4% rule to your retirement fund withdrawals isn’t a good idea, for several key reasons:
- Your portfolio is likely dissimilar to the one used in Bengen’s research, and this makes a big difference to the sustainability of your withdrawals.
- After thirty years, with your assets depleted, you might still be alive and well.
- The model doesn’t account for Investment fees and taxes. These things are unavoidable in retirement.
- Your spending needs may vary during retirement, depending on your circumstances.
- Ultimately, the 4% rule is a one-size fits all solution to a problem that needs a personal approach
Which is where a forward-thinking financial planner can help. By using cutting-edge technology, we will create a highly personalised – and adaptable – strategy that suits your specific lifestyle goals and requirements.
Hope for the best, plan for the worse
A robust withdrawal strategy is designed to give you financial security that would see your portfolio withstand any number of catastrophic events from the last century, including World War 1 & 2, the Great Depression, and the more recent financial crisis in 2008. But it’s not all doom and gloom; there’s a decent chance you’ll live through good times too! The trick is to balance out the best and worst case scenarios and calculate a ‘success rate’ of your portfolio
How can you calculate your success rate?
This is where probability comes into play. It’s used by professionals in many fields, from surgeons to financial actuaries and football managers. In essence, it’s how likely a plan is going to stay on track, and if it does veer off course, being able to correct your approach down the line.
As experts in financial planning with access to vast amounts of empirical data from a century or so of investment history, we can develop a withdrawal strategy for you that aims for a high chance of success. For example, if your plan shows an 80-90% chance of meeting your goals, this means that 80-90 times out of 100 in the last century, your withdrawal strategy would have been successful during your retirement.
What if you don’t meet your success rate?
Retirement planning is an ongoing process. This means you might need to make course corrections along the way, such as reducing your withdrawal rate, or changing your asset allocations.
Of course, the higher your success rate is, the less chance the need for this will occur.
Rule-based withdrawal strategies
Rule-based strategies are safeguards to help you stop running out of money.
Typically, these rules involve adjusting your spending gradually downwards if you face poor returns early in retirement.
Examples of rule-based strategies:
Guyton Inflation Adjustment
This approach involves adjusting your withdrawals for inflation each year except after a negative portfolio return.
Cap & Collar
Under this approach, you set an upper (cap) and lower (collar) inflation limit. You adjust your withdrawals each year for inflation.
Guardrails
You can reduce or increase what you spend based on a pre-defined percentage of your initial withdrawal rate.
Other considerations
A healthy cash emergency fund
Easy access cash savings play a vital role in a robust withdrawal strategy.
Drawing on cash, instead of your portfolio during a market downturn can help to mitigate sequencing risk. When working with you, we agree an optimal amount of cash you should aside and can advise on the best home for this too.
Is an annuity right for you?
If you are reliant on pension savings to fund your ideal retirement, a secure income for the rest of your life (achieved with an annuity) could be the best option for you. This isn’t without complexity, but it is something we always consider for you at the start of your retirement journey.
We wrote about annuities and understanding your different options recently.
Of course, each strategy has pros and cons. A good financial planner will advise you on what approach will work best, using complex modelling to present clear visualisations on how these strategies might fare under a wide range of market conditions.
You are unique, and so is your retirement journey
Which is why it’s important not to apply a one-size fits-all solution to managing your retirement wealth.
Here are some of the things we consider when delivering a highly personalised, and tailored financial plan:
How you want your money
What level of income do you desire from your portfolio? Do you need to make any lump-sum withdrawals? And how prepared are you to adjust your strategy, should market conditions be less favourable?
Your longevity
How is your health and how long are you likely to live? Although if you could tell us that, you probably wouldn’t need our help…
Fees and taxes
When Benjamin Franklin said nothing was certain in life, except death and taxes, he forgot to mention fees. These include the likes of income and capital gains taxes, advisory fees and other investment costs. No investment is free.
Investment strategy
How much should you keep as an emergency cash fund? What are your asset allocations? What accounts will you make withdrawals from first? How comfortable are you with investment risk?
Your legacy
Do you want to leave money to your loved ones? Or donate to a cause you care about?
If you don’t know the answer to these questions, DON’T WORRY!
This is where a financial planner, who will take the time to establish what your exact needs are, can help. We will create a robust and reliable strategy that is highly personalised to you, and continually monitor your plan to keep you on-track.
Agreeing a withdrawal strategy that works for you
After agreeing the best approach to withdraw money from your portfolio, it is then written out in a Withdrawal Policy Statement (WPS). This document lays out the guiding principles for how your retirement portfolio will be managed. It will include:
- Your income objectives.
- Any legacy requirements.
- Definitions of the parameters you wish to guide future withdrawals and adjustments. A method for assessing whether your plan is still on track to deliver your objectives at each stage of your retirement journey.
Your WPS will also record how you wish to approach unexpected changes in the financial landscape. Nobody can anticipate every market condition – not even a financial planner – but with a WPS in place you will have a reassuring framework for what steps should be taken should the market change rapidly.
Can you proceed without a WPS?
You can of course withdraw from your investments without a WPS in place. However, if you don’t know all the risks, this can be dangerous, and have a direct impact on your financial security. Having a WPS agreed up-front with your adviser makes the process more secure, and easier to manage.
Navigating an effective withdrawal strategy
The point here is that managing a withdrawal strategy effectively isn’t a set-and-forget approach. It requires regular review, and a financial planner who can recognise if course corrections are required, to ensure you enjoy a fulfilling and financially secure retirement.
Supported by technology
Should market conditions affect your plan in any meaningful way, we are alerted instantly. If things need to be adjusted to ensure your retirement journey remains on course, we can then review our agreed plan, consider what changes might be required, and discuss them with you before getting things on track. As Dwight Eisenhower once said: ‘Plans are worthless, but planning is everything.’
Investment risk information
Please note, the value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
This information is for general information only and does not constitute advice. The information is aimed at retail clients only.
Past performance is not necessarily a guide to future performance.
If you would like to find out more about our retirement planning service then please click on the link below.