Choosing the right investment risk in retirement is absolutely crucial. It will impact:
- How much money you can spend in retirement.
- Whether your retirement savings pot will run out.
- What you can leave behind for your loved ones.
- How much stress you have to deal with when stock markets fall.
In my experience, there is a natural tendency to want to protect what you have once you retire and therefore err on the side of caution.
But is this right?
Let’s look at what happens when you choose to go cautious with your investment risk in retirement.
How history has shaped views of investment risk in retirement
Before 2015 there wasn’t much choice in terms of how you could receive an income from your defined contribution pension.
At retirement age your pension provider would write to you and offer you their annuity rates which allowed you to convert your pension pot into a secure income for the rest of your life. This was the low risk option on the one hand as you didn’t need to worry about what the stock market did in retirement and you always knew what income you would be getting. A risky choice on the other hand if your circumstances changed as you could not reverse this decision.
You did have the option to go for pension drawdown which usually resulted in you having to transfer your pension to a drawdown provider, your pot remained invested and you could drawdown money on a more ad-hoc basis. Unless you had other guaranteed income of £12,000 per year, you would be limited as to what you could withdraw (known as ‘capped drawdown).
According to the Pensions Policy Institute there were 189,000 annuity sales in 2014 making it by far the most popular choice for retirees.
As annuities were worked out based on gilt yields (interest rates) at the time, you always wanted the biggest pension pot possible at retirement. If your pension pot fell in value just before retirement then this resulted in less pension income.
A good way to show this point is to look at what happened if you had retired at the beginning of March 2009, during the ‘Financial Crisis’. In the example below we can see two different retirees both starting off with a pension pot of £500,000. One is taking lower risk with their investments and the other is taking higher risk.
|Investment strategy||Investment fall (31/10/2007 – 06/03/2009)||Loss of pension value||Pension left to purchase annuity||Pension annuity income (based on 4.5% rate)|
(Mixed investment 0%-35% shares)
|-16.78%||-£83,900||£416,100||£18,724 per year|
(Mixed investment 40%-85% shares)
|-29.44%||-£147,200||£352,800||£15,876 per year|
So you can see that by taking a lower risk investment strategy in this example it secured an extra £3,000 per year in pension income.
This point was the reason the whole pension industry guided people towards lower investment risk in retirement.
Even today I get the feeling the financial regulator would still like to see most people take an annuity at retirement and there have even been investment strategies designed that automatically de-risk your pension investment portfolio as you approach your selected retirement age. These are known as lifestyling funds.
Investment risk in retirement now we have ‘Pension Freedoms’
By 2019 annuity sales were down to 49,000. Why?
Well in 2015 the government launched Pension Freedoms which gave people the freedom and choice to do what they wanted with their pension savings. No compulsory annuities, no caps, just take out what you want, when you want (subject to taxation).
This has changed the whole conversation around investment risk in retirement.
As life has changed and people require much more flexibility in retirement you will probably want your pension income to be flexible too.
This is now absolutely possible but as you are now keeping your pension pot invested there are two further risks to factor in:
- Longevity risk
- Inflation risk
Whereas before Pension Freedoms, if you were purchasing an annuity your investment timeframe may have been short, now you have to ensure your pension pot lasts the rest of your life.
How long is that? Well, for a 60 year old today there is a 16% chance of reaching age 95 and a 4% chance of reaching age 100. So potentially a 35-40 year retirement!
In my experience, even though people are now more familiar with the freedom of choice they have at retirement they are still naturally cautious. You want to protect what you have. You may want to utilise pension drawdown but you want to remain cautious in your investment strategy. After all, you are not going to be toping the pension pot back up if you’re in retirement.
But let’s look at the income that could be sustained in real terms (inflation proofed) from a pension pot of £500,000 and a State Pension using different investment strategies over a 40 year retirement. To find out this data we have run these different investment portfolios through the last 100 years of global market data to work out the worst possible time to retire.
For risk we have used a scale of 0-10 with 0 being the least volatile and 10 being the most volatile.
|Investment Risk||Worst time to retire||Maximum sustained spending|
|Level 0||September 1967||£12,100 per year|
|Level 5||December 1968||£29,400 per year|
|Level 10||December 1968||£34,700 per year|
These results show that we need to fight our natural urge to be cautious in retirement and opt for a suitable investment strategy that is going to deliver growth over the long term.
Why does a higher risk strategy work better? Because financial markets are up more than they are down. The highs tend to be bigger than the lows and the best gains are made after the worst falls.
But, this analysis is based on a consistent level of spending. We do still need to be careful of something called ‘Sequence Risk’. This is where you suffer significant investment falls at the start of your retirement and you take larger sums out of your pension pot.
Using the same scenario above, if a retiree was using risk level 10 but as well as spending £34,000 per year they also withdrew £100,000 from their pension pot to pay off their mortgage at the start of their retirement, they would have run out of money by age 74 in the worst case scenario.
So be prepared to take investment risk in retirement but make sure it is the right risk for you. Make sure your retirement plans are tested.
Flexibility in retirement works both ways. You can have your pension income flexibly in retirement but you also need to be flexible with your spending in retirement.
If you would like your retirement plans stress tested and an optimum investment strategy picked for you then please schedule a no obligation free 15-minute call.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.