There are financial needs and goals at every stage of life, and a well-structured wealth plan, that is unique to you, will help you progress and, ultimately, achieve these goals. By the time you reach your 50s and 60s, having accumulated sufficient wealth for your retirement, the hard work is now done and you have reached one of your goals – to retire. Your plan is complete. Or is it?
The answer is not necessarily. This is because the time spent as a retiree, having taken steps to slow down the pace of life, is actually far more of a challenge financially than your life to date. You have reached a potentially complex stage called decumulation.
The dilemmas you face are partly due to the number of decisions you have to balance when relying on your accumulated, but potentially finite, investments, pensions and savings to either completely fund your spending needs, or top up your reduced earnings as your sources of earned income become fewer.
As well as the ramifications of becoming increasingly reliant on your investments, pensions and savings – sometimes for 40 years or more – complexity also lies in the number of additional risks you become exposed to beyond those categorised as investment risk.
So what risks should I be aware of?
Although most conversations you have about risk actually focus on the umbrella category of investment risk – which still applies in decumulation – we believe there are three additional key risks you should understand:
1. Inflation risk
If you have opened a newspaper recently and turned to the financial pages, it is highly likely that many of the headlines will have focused on inflation. The debate centres around whether the price increases (under the banner of inflation) are likely to be temporary (i.e. the rate of increases will start to quickly decline as ‘normal’ economic activity returns) or whether the higher levels recently experienced will continue over a prolonged period.
Inflation can be called the ‘thief that keeps on taking’. Compounded over a long time, inflation can have a significant impact on the real value of your money. An inflation rate of 3% per annum over 10 years, as an example, actually means the value of money is eroded by around a third.
During accumulation, any additional income earned and new funds tend to hide the real effect of inflation. So, you only really become aware of the ravages when you have lower levels of income.
Inflation is most concerning when the rate is higher than the return generated by any low risk investments you may hold – and the longer inflation increases remain, the more likely it is for those price increases to perpetuate themselves. Unfortunately, in modern times, people are not used to having to deal with inflation and may struggle. If you live in the UK, as an example, inflation has been relatively benign since the mid-90s, so why would you have dealt with it?
Regardless of the debate being forged by central banks, it is also worth understanding that your own level of spending determines your personal level of inflation, depending on the goods and services you’re buying. You could even find your inflation rate is actually higher than the monthly figure published by your national government.
2. Longevity risk
Medical advances and an ever increasing understanding of how we can maintain better health mean we are typically living longer than ever before. The benefits of being active for many more years and spending more time with loved ones are clear, but they come with the risk you could outlast your wealth.
A couple in their early 60s today – and it’s estimated that about 75% of the UK population are part of a couple – has a 25% chance that at least one of them may join the exclusive club of centenarians. Many people doubt their chances of living past their 100th birthday, but it’s a probability you should take into account to ensure your financial future stands the test of time.
3. Sequence risk
Often confused with volatility – which is the measure of market increases and decreases in value – sequence risk is the more pernicious and is not very well understood. The risk is created by a combination of the sequence in which returns are generated and by continual withdrawals from the portfolio. If investment returns are weak in the earlier years of retirement, coupled with unsustainably high withdrawals, the two can dramatically impact the long-term value of your portfolio, irrespective of whether you see higher investment returns later on in your retirement journey.
Sequence risk is generally highest at the start of the decumulation stage, when you begin to rely on your financial assets to fund your spending and when your time horizon is the longest.
However, while sequence risk is often a matter of luck, there are steps you can take to mitigate its impact.
So what help is available?
One of the questions we recommend any client should ask their wealth manager is whether they have specific services aimed at supporting them throughout retirement. Many don’t, as they have a focus on investing in accumulation, and yet the various aspects at play and the balance you need to achieve in retirement mean you should seek a specific service which focuses on decumulation.
In addition, throughout the accumulation stage, you may have taken advantage of the tax allowances, exemptions and reliefs available to you, and invested your money into vehicles, such as ISAs and pensions. In retirement, it is just as important, if not more so, to use these as thoroughly as possible. As such, it is essential you withdraw from your investments in a particular order that will be unique to your circumstances.
For example, it is often the case that drawing from the least tax-efficient investments first is prudent. This allows the more tax-efficient investments to grow and reduces the effects of the cost of tax dragging on your investment returns. However, it is vital you understand your overall goals before determining which investment to draw on first. Say, for example, you are planning for the next generation, you may want to leave your pension untouched given these are considered to be outside of your estate for inheritance tax purposes.
Active investment management is key
In addition to the wealth planning support, you should make sure your investment portfolios are being actively managed. Not only will active asset allocation help mitigate the effects of inflation risk, which we described earlier, but it will also help you benefit from the various underlying characteristics of individual asset classes. For example, an asset class we regularly invest into is property.
Our difference, however, is we would always seek to do so via investment trusts. These can be sold down even in very volatile markets due to their closed-ended nature, and at times when other (open-ended) property funds are likely to quickly be gated, as we saw in the months following the Vote to Leave in 2016 and again in 2020. The easily accessible, liquid nature of investment trusts is extremely important to retirees in decumulation, given you could need to access your investments at any time.
In addition to the use of active asset allocation in generating returns, an important aspect of meeting retirement withdrawals is rebalancing. While the approach is not relevant for every client, many would benefit from a dual portfolio approach, where your portfolio would be split and managed across two levels of risk.
In this scenario, the cautious risk portfolio has the objective of lower-volatility, steady returns to meet your withdrawal profile, while the higher risk portfolio aims to provide longer-term growth over your retirement period. The more cautious portfolio serves to protect more of your capital from large market movements, due to the mix of asset classes typically held, and helps to mitigate sequence risk. The second, higher-risk portfolio, meanwhile, is usually invested in riskier assets, such as equities and property, which help you to manage both inflation and longevity risks.
Active rebalancing from the higher risk portfolio to the more cautious risk portfolio needs to be undertaken when the time is appropriate to ensure that the level of investment risk across both portfolios is in line with your overall risk profile and tolerance. Through the dual portfolio approach, active investment management and active rebalancing can help overcome the competing risks of longevity and sequence.
Ultimately, however, we also realise that many of the reasons behind your choice of a wealth manager is not just down to their technical expertise, but also whether they have really listened to your needs and treat you as a valued client – and not just a number. You also need to be confident that the same due care and attention will be paid to you today will continued to be the case in the decades to come, year in and year out – an approach we are always happy to explain.
This article is part of a series of updates written to help you understand the complexities linked to life as a retiree. More articles and updates can be accessed here, as well as details of our retirement planning support.
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Clients of Nedbank Private Wealth can get in touch with their private banker directly to understand how wealth planning can help them achieve their financial goals and objectives, or call +44 (0)1624 645000 to speak to our client services team.
We do not offer a tax advisory service and nothing in this article constitutes tax advice. We would always recommend you seek professional tax advice in relation to the impact of any investment structure or transaction on your personal tax position. We are, however, happy to work with your tax advisers, or to provide an introduction to a suitable tax adviser should you wish.
Any examples of investments and structures used are for illustrative purposes only. The inclusion does not constitute an invitation or inducement to buy any financial investment or service. None of the content constitutes advice or a personal recommendation. Individuals should seek professional advice, based on their jurisdiction and personal circumstances, before making any financial decision.