Will your client's retirement pot last as long as they do and what are the five main risks to their investments?
Few people have sympathy for those lottery winners who collect their big cheque and after a massive spending spree, find their new wealth did not last quite as long as they had hoped. Most of us take the view that, with a little forethought, such a windfall could be carefully managed to last a lifetime - or more.
Why is it then, so few people spend any time at all planning how to make their retirement pot last as long as they do?
Fewer workers today can expect to enjoy a guaranteed and perpetual income during retirement. Instead they must seek out the fruits of their DC investments and supplement the income from it with any other wealth they have accumulated during their working years. With all the emphasis on accumulating assets during working years, there is a real danger that new retirees fall into the lottery-winner's trap and fail to provide for what could be decades of retirement.
The biggest risk people face is not saving enough. But even if an investor has cleared that considerable hurdle and retired with a comfortable sized investment pot of DC pension funds and other investment assets, we think there are five risks that threaten people with retirement poverty.
Longevity. Yes, we all know we are living longer, but do the real implications of this register with most people? Some of the blunt facts make the point clear; half of all men who retire in good health can expect to live another 22 years to reach the age of 87. A quarter of those will live well into their 90s. Half of all healthy 65-year-old women will reach their 90s. For a woman who retires at 60, that means a 30-year retirement living off what is often a less generous pension pot than a similar aged man. The answer here is to be realistic about how long retirement might last and stick to an investment strategy that provides for the whole period of time.
Inflation. This is amplified by the first risk. Over these long periods of time, rising prices can evaporate a healthy income stream to become a meagre trickle. Today's inflation debate is finely balanced. On the one hand, the recession has quashed last year's inflationary pressure; but on the other, huge government spending and the East's unstoppable growth are turning the inflation heat up once again.
To an extent, the inflation debate is irrelevant because even modest price rises will cripple badly invested portfolios. At the government's target rate of 2% inflation, £50,000 is worth almost 40% less in 25 years. For some people in retirement, especially anyone who spends more than the average household on energy bills, inflation can be a big worry. Other retirees might find their expenditure declines as they become less active, but even so, provision for inflation must be made in investment planning.
Asset allocation. This is both a risk and a solution to retirees' problems. The natural progression in the transition into retirement is to de-risk a portfolio and concentrate on income generation. This is the right thing to do, but going too far and becoming too defensive can be as damaging as remaining too aggressive. Retaining some growth assets in a retirement portfolio might seem counter-intuitive, but is often the way an investor powers their portfolio through a long retirement. A sensible asset allocation strategy should balance the need to generate a reliable income, preserve capital and grow sufficient capital (the fuel for income generation) over the whole retirement period.
If insufficient growth is achieved, the investor will have no option but to eat into their capital and discover the fourth risk.
Withdrawal risk. This point returns to our imaginary lottery winner. In essence, if the investor withdraws too much from their portfolio's capital, it will not last their whole retirement.
While the general principle is simple, deciding what amount to withdraw from a retirement investment regularly is rather more complex. The value of the portfolio, expected length of retirement, income requirement over any pension and investment performance are all variables in the equation. In stochastic modelling, which takes account of real investment performance rather than simple arbitrary example growth rates, it is clear that every 1% added to the amount withdrawn takes several years off the portfolios' lifespan. People approaching retirement tend to think their pension will cover all their income needs so the vast majority of retirees have no idea how or how much they will draw from their non-pension retirement investments.
Of course, for all the modelling and well-meaning planning in the world, retirees need an income at least equal to their expenditure which can sometimes run away from them. This is where the final risk lies.
Long-term care expenses. While I acknowledged earlier that certain retirement expenditure falls as the years pass, for some people retirement expenses rise in ill health due to long-term care costs that are increasing faster than inflation. Most people wealthy enough to seek financial advice are also wealthy enough not to qualify for state-funded long-term nursing costs. This saddles many people with a huge financial burden at a time when they have little reserve capital.
Ending work with sufficient assets to sustain a healthy and happy retirement is for many the reward of decades of hard graft. For those people as much effort should go into planning the long life of their retirement investments as goes into accumulating the wealth that creates those assets. Neglecting to take the right action into and throughout retirement risks unravelling all the good work done while accumulating assets.
Julian Webb is head of defined contributions at Fidelity International.
