There has never been a greater need for retirees to engage with their advisers regularly to ensure their retirement stays on track and that their pension pot survives for at least as long as they do. This is just as well because when it comes to taking pension income from savings, also known as ‘decumulation’, retirees need to come to terms with a number of new realities.
New reality #1: Annuities are no longer for everyone
There are many good reasons why advisers need to spend time explaining the potential benefits of an annuity for UK expats returning home. However, these days only the wealthiest or the oldest can afford to make a traditional annuity a large part of their pension planning because the cost of the guaranteed income they offer has simply become too high.
For most UK expats approaching retirement, being confronted with the high costs of guaranteed income will mean that they need to consider using risk assets such as equities, bonds and alternatives as a better way to deliver the secure long-term income that they’ll need in retirement.
New reality #2: Your pension pot can live on long after you do
The removal of the ‘death tax’ of 55% on inherited pension assets in the UK has made pensions one of the most tax-efficient ways to pass assets from one generation to the next as they have always been free of inheritance tax (IHT).
This change has given a new lease of life to the estate planning market and, along with record high transfer values, helped to trigger the deluge of defined benefit (DB) pension transfers we’ve seen in recent years. Such transfers present the opportunity for pension holders to enjoy similar levels of income, more tax-free cash, greater flexibility and the chance to pay less tax in retirement. They also offer the very real possibility that – with careful management – a substantial pension pot could still be available at the end of their lives to pass on to loved ones.
This potential only increases the need for most UK expats to talk through their changing requirements with their adviser to ensure their retirement stays on course.
New reality #3: How you manage the ‘big three’ risks will dictate your quality of life in your old age
The three big risks that every adviser must help their clients to understand are:
Longevity risk: The risk that a client will live too long for their pension pot. To counter it, they’ll need to take a view on their likely life expectancy and ensure the level of income they take won’t erode their pension pot.
Inflation risk: Inflation risk is the secret killer. It suddenly becomes an extremely destructive force when someone reaches retirement and stops making contributions to their pension pot.
For example if UK inflation runs at the current annual rate of 2.4% it will erode more than 20% from the value of a UK pension pot in the first 10 years. Scroll forward another decade and very nearly 40% of their pot will have gone in terms of real spending power.
Sequence of return risk (or pound cost ravaging): This is the increased risk presented by a fall in returns that comes early in a client’s retirement as opposed to later down the line.
This will come as news to the average retiree because so long as they were in the accumulation phase of their retirement planning, the order in which they got their returns never really mattered.
The opposite is true for clients in decumulation; once they start taking income they effectively cement any losses which can cause irrevocable long-term damage to the value of their pension pot.
New reality #4: Sitting in cash is no longer a safe option
Clients need to understand the role cash plays in a decumulation portfolio. For those still in the accumulation phase, cash provides a safe haven from market volatility and valuable liquidity for a portfolio. However, cash soon loses its lustre in decumulation.
This is because with interest rates so low, cash delivers a negative ‘real’ return after inflation and has done so since the early part of 2009. At current levels, UK inflation will eat over 20% of a cash pension pot in the first decade. However, the real damage comes from using a depreciating asset like cash to fund regular income withdrawals. There is no better way to terminally deplete a pension fund.
By shunning investment risk in favour of cash, many investors risk depleting their pension pots long before their longer lives come to an end.
New reality #5: Tomorrow won’t look much like today
Thanks to our cognitive biases, humans have a natural tendency to approach situations in the context of their recent experience. This is referred to as recency bias. This can be especially dangerous when it comes to investment for obvious reasons.
For example, in September 2018 the US stock market explored record highs as the longest bull market in its history continued to play out with its ‘trophy room’ of the world’s best-known tech names doing most of the heavy lifting. The picture was quite different in the UK and Europe, which have mostly traded sideways this year, while emerging markets actually fell into bear market territory early in September after racking up significant returns in the decade since the financial crash.
All this means that pension savers have done extremely well over the last decade – especially those who embraced risk assets. It also means that too many retirees consequently see no need to change the investment approach that served them so well while in accumulation.
Any retiree who relies on their accumulation strategy to deliver on their changing income needs in retirement in the next few years is taking a huge risk. If markets change direction significantly in time – which they surely must as this cycle matures – then ‘sequence of return risk’ could well pull the rug from under their retirement.
Of course, the clock is ticking; there won’t be any prizes for those advisers who waited until markets had gone into reverse before they helped their clients to recalibrate from accumulation to decumulation.
** Quilter Investors, the sister company of Old Mutual International, is the multi-asset business of Quilter plc.