For many investors, the biggest worry and the nightmare scenario is running out of money during retirement in the decumulation phase.
In a bid to tackle this issue, investors must know why this scenario could take place.
There are five reasons investors might outlive their retirement savings:
1) Mismatch between wealth and lifestyle
2) Effects of exposure to adverse market price risk and sequence of return risk
3) Higher-than-expected inflation
4) Living longer than expected
5) High care costs associated with declining health.
Some investors may not like to risk running out of money in decumulation – and there has been a rise in many Brits taking out annuities instead of drawdown.
According to the ONS, people aged 65 years in the UK in 2020 can expect to live on average a further 19.7 years for males and 22 years for females, projected to rise to 21.9 years for males and 24.1 years for females aged 65 years in 2045.
The ONS Life Expectancy Calculator suggests that a 65-year-old male has a one in four chance of reaching the age of 92 (94 for females), and a 3% chance of reaching 100 (5.6% for females).
Therefore, safe retirement plans need to ensure that savings will last long enough to cover all realistic scenarios for life expectancy, considering the cost of later life care.
No one-size-fits-all
Navigating factors when it comes to maximising pension savings, thinking about care home needs and helping the next generation is not a one-size-fits-all approach.
It depends primarily on the amount of wealth people have relative to their desired lifestyle. The larger a person’s net worth, the smaller the risk of running out on money.
Wealth includes the equity in a person’s property and any other net savings or assets as well as the pension fund, while living costs are partially offset by the state pension and any other income source.
The smaller the wealth relative to income needs, the more reliance needs to be placed on lower risk products such as annuities. For many with smaller savings, annuities and state pension will need to be accompanied by changes in lifestyle to make ends meet.
Of course, wealthier retirees enjoy more options, provided their income expectations don’t get out of hand. Many wealthier retirees choose to keep their investment portfolios running into retirement with little or no change in risk or style.
While this does allow continued portfolio growth, it comes with risks. Poor market performance, particularly at the beginning of the decumulation phase, can mean that expected portfolio growth doesn’t happen.
In many cases, a blended approach using guaranteed income products or smoothed funds alongside a market portfolio can provide protection against poor market outcomes while still benefiting from expected market growth over time.
Decumulation approach
Many people tend to think that the 4% withdrawal figure is a good rule of thumb.
Our modelling suggests that for a fit 70-year-old man with a high risk (100% equity) portfolio, a 4% withdrawal rate produces a 15% probability of being exhausted prior to age 96 (1 in 10 survival point).
For a more traditional 60/40 equities / bonds allocation, the probability of running out of money by age 96 reduces to 7%, but this is accompanied by a 35% reduction in expected portfolio value.
Increasing withdrawals from 4% per annum to 5% per annum increases the risk of depletion from 15% to 28% (100% equity portfolio) and from 7% to 21% (60% equity portfolio).
This suggests that a 4% withdrawal rate is already somewhat risky, and that increasing to 5% is quite dangerous. Interestingly, feeding in an element of guaranteed income into the model can substantially reduce the risk of running out of money while increasing expected portfolio value.
Historically, annuities have provided explicit inflation protection, but that is no longer the norm. A common approach is to assume that equities (and potentially property assets) will broadly keep pace with inflation, and therefore to allocate a proportion of the portfolio to equities.
Ultimately, if savings are insufficient (or suffer market losses) then there is little choice other than to rely on state pension and state care, but an early appreciation of the problem will allow a retiree to adjust their lifestyle to extend the period of private pension cover.
Preserving pensions and your legacy
Many typical conversations tend to surround people using ISA cash, private pension and deferred state-pension as a fall back after they use all their savings and investments.
Doing this will depend on personal circumstances, but increasingly it makes sense to preserve private pensions as a potential legacy.
Pensions are hugely complex and many of the products on offer are expensive and opaque. Investors need to take financial advice. Advisers have access to cashflow modelling tools and up-to-date product pricing. This is an area in which a good adviser is essential and can provide huge added value.
Mark Northway is investment manager at Sparrows
