We’re all going to die… wealthy?
The 2015 pension reforms changed the way you take income in retirement. But with freedom comes responsibility. You now have to work out how to make your pension last, so you don’t run out of money.
That means deciding how much money to take out each year and setting the right investment strategy. It goes without saying that your pension won’t last as long if you take a lot of money out of the pot early on. But what should you invest in?
The problem is that two of the key things that ‘everyone knows’ about retirement planning could be wrong. The first is that you should sell riskier assets as you approach retirement; the second is that you should increase your exposure to higher-yield income funds or strategies.
The danger of such flawed thinking is neatly summarised by Daniel Kahneman, the Nobel prize-winning psychologist: “The planning fallacy is that you make a plan, which is usually a best-case scenario. Then you assume that the outcome will follow your plan, even when you should know better.”
Fallacy one: you should de-risk before you draw down your portfolio.
Ironically, a low-risk strategy may prove to be quite risky as your portfolio may fail to generate the returns needed to replenish drawdowns. A 65 year-old could live for another 20 years or more, so post-retirement investing is still long-term investing.
It could be tempting to lock in past gains by shifting everything into cash when you start to draw an income, but playing too safe can mean the investments stop growing. Some risk is desirable as it is more likely the portfolio will be able to generate a sustainable income stream over the long term.
In 2007, annuity rates for £100,000 were around 7.5%. If you had shifted your portfolio to cash in order to reduce risk, then drawn £7,500 per annum, you would only have £27,000 left by 2017 – and facing the prospect that the pot would soon be empty.
Even allowing for the huge sell-off during the global financial crisis, if you had remained invested in ‘risky’ UK equities, in 2017 you would have £48,000 left – a significantly better situation.
Fallacy two: it is better to earn ‘natural income’, so that withdrawals come from income and your capital is left intact.
Thanks to central banks’ money-printing strategies since the financial crisis, low yields have been the norm over the last decade and, while interest rates are now rising, lower yields seem here to stay. If you’re looking for yields similar to those of 20 years ago, you have to consider non-traditional asset classes beyond even high-yield credit, such as aircraft leasing or peer-to-peer lending, which typically involve high default risk.
In difficult markets, a portfolio comprising such assets could be illiquid, volatile and poorly diversified. This could result in unpredictable income streams and lead to large losses in early years, increasing the risk that the portfolio will be depleted before time. Moreover, the high default risk incurred in the process can pose a risk to capital, especially because interest rates are more likely to go up from here rather than down.
In a world of misconceptions, are there any solutions?
Fortunately, in debunking the myths around investing for retirement, all is not lost – multi-asset investments can be the answer. Capital risk is a key factor, and it matters more when you draw down on your pension pot than during the accumulation phase (see charts). We believe that after retirement, when drawing down your portfolio, a multi-asset strategy that involves unit encashment – withdrawing capital and income – can be more prudent than chasing yield by investing in untested asset classes, or going to the other extreme and de-risking altogether. This allows you to achieve diversified total returns through exposure to a broad range of asset classes.
Drawdowns: worse when drawing an income
Source: Royal London Asset Management, for illustration purposes only. Calculations shown make no assumption about yields and are based on total return.
Forward-looking projections show how a multi asset approach can help you to grow your pension pot, so you can sustain a reasonable level of retirement income. For a pension pot of £100,000 we believe an income of around £4,000-£4,500 a year is likely to be sustainable long into retirement. This is similar to the level of income on offer from annuities today, but a drawdown pension gives you much greater flexibility and a higher likelihood of having something left to pass on to the next generation.
Retirement is a journey. The pension freedoms give you a high degree of control over your own pension pot, but there are hidden dangers in choosing the right investment strategy and in deciding the appropriate level of income to draw out. Identifying the appropriate level of risk for your long-term investments and taking a multi-asset total return approach could help you to enjoy, rather than endure, your retirement.
Source: Royal London policy paper 18 – Avoiding Hidden Dangers in Retirement
For professional clients only, not suitable for retail investors.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.
All information is correct at November 2018 unless otherwise stated. Issued by Royal London Asset Management Limited, Firm Registration Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number: 144032, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland.
All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064. Our Ref: AL RLAM ON0020.