“The question isn’t at what age I want to retire, it’s at what income.”
You are a long time retired!
Thirty years ago, securing an income in retirement was relatively simple; collect years of service in the company’s pension plan and retire on a defined percentage of your final salary. Today, for most, the risk and financial burden of securing a retirement income has shifted from companies and governments to individuals. Turning investment assets into a stable income that will support a retiree’s expenditure throughout the unknown length of their retirement is a complex problem. There are no easy solutions, as markets do not deliver consistent returns and the sequence in which these returns are experienced matter.
The sequence in which returns occur matters when taking an income
Let’s look at the impact of the sequence of returns in two scenarios.
- A £1,000 lump sum pot that has no additions or withdrawals.
- A £1,000 pot from which a withdrawal of £100 is made each year.
We will use the following 10-year hypothetical series of annual returns (Table 1), which delivers an annualised return of 4%, whether experienced ‘forward’ or in ‘reverse’.
Table 1: 10 years of hypothetical annual returns – forward and reversed sequences
Scenario 1 – A £1,000 lump sum pot that has no additions or withdrawals
It makes no difference, in the end, because 1 X 2 X 3 (‘Forward’) is the same as 3 X 2 X 1 (‘Reverse’), as the table below demonstrates.
Table 2: Scenario 1 – A £1,000 lump sum pot that has no additions or withdrawals
As soon as money flows into or out of the pot, the sequence in which returns are experienced has a material impact on outcomes, as we can see below.
Table 3: Scenario 2 – A £1,000 pot from which £100 is withdrawn each subsequent year
This scenario equates to taking an income in retirement. Even though the return sequences both deliver the same outcome on a portfolio with no cashflows, in a withdrawal scenario, weak returns and withdrawals in the early years (‘Reverse’) deplete the portfolio substantially, and when the better returns come in later years, these returns are applied to a far smaller portfolio balance. The result, in this case, is an impecunious retirement for those experiencing the ‘Reverse’ sequence. Whilst, withdrawing £100 (or 10% of the starting balance) is unrealistically high, the point is made. The sequence of returns matters, and upfront and ongoing planning is essential.
The value of retirement advice
It is evident that many people in, or approaching, retirement need to take advice from a well-qualified and experienced financial planner. Choices to transfer from a final salary scheme, buy an annuity or set up a withdrawal strategy are highly complex. Tax and regulation make an already complex issue, even more challenging. Modelling an individual’s circumstances and evaluating and understanding his or her requirement for income certainty is key. At that point, building a suitable portfolio and withdrawal strategy – perhaps encompassing some pre-identified strategies for dealing with poor market outcomes – is the next critical step. This is not a set and forget process. An insightful discussion on the progress of the withdrawal strategy is needed on an annual basis. Recognising and understanding the possible challenges ahead – and dealing with them before they become problematical is central to success. In most cases these events won’t arise. But if they do, that is when a good adviser will earn his or her weight in gold.