Final salary pension
Low risk inflation linked portfolio
|Source needs to be secure and inflation linked
|Diversified investment portfolio
||Volatility is acceptable in line with the flexibility of spending
It didn’t use to be quite so difficult. The 4% rule – where you spent 4% of your savings each year and increased it by inflation – used to work. But that was at a time when investment yields were much higher and life expectancy shorter. A successful plan means taking a calculated view on risks, principally two of them: life expectancy and investment returns.
We can all check to see what our average mortality is but there is a surprisingly wide variation around this figure. There’s a neat tool from the Office for National Statistics that you can access here.
That helps to show the probabilities, but it doesn’t actually tell you when your life will end. The only way to insure this risk is through an annuity.
You might think it would be crazy to buy an annuity when yields are so low but it’s still worth considering as you get into your 70s, at least to cover part of your spending. By that stage the low level of gilt yields has less impact because you are mainly receiving a return of your capital. The critical point is that you’ll continue to receive that payment for exactly as long as required. If you live longer than average your payment is subsidised by those who are less fortunate.
The benefits of not buying an annuity are the potential to pass on a legacy plus extra flexibility over your spending. An unexpected health scare or property maintenance bill can be awkward if you are mainly relying on a regular monthly annuity cheque and have little in the way of liquid assets. However, it’s critical to understand that when we retire we become more vulnerable to investment risks – especially early in the period. This is known as ‘Sequencing Risk’. It’s a bit technical but basically it means that experiencing a bear market soon after you retire is much more damaging than if it happens later. It leads to ‘pound cost ravaging’ whereby you have to take out a higher proportion of your portfolio to cover your spending than is sustainable.
You can control your investment risk to a large extent by adjusting your risk profile. For example you might decide to move from Adventurous to Cautious. However, that also reduces your potential for additional return and might not be the best choice at normal retirement ages when the realistic time scale is still at least 20 years. It depends on your personal sensitivity – if you are going to be worrying every time the stock market falls then that is not a good recipe for a happy retirement.
Once you have developed a plan it will need to be reviewed regularly, at least annually. A detailed cash flow projection will help to identify how much risk you are taking. EQ can help you create this plan and keep it relevant.