A pre-retirement planning exercise is essential to ensure pension funds deliver a comfortable retirement. One of the issues to consider when preparing a retirement plan is risk. In this post, we cover the key elements of risk and how they may be managed.
The Key Elements Of Risk
When anything is uncertain or unpredictable there is an element of risk involved. The more unknown factors involved, the higher the unpredictability and the higher the risk.
With any investment, there is a level of uncertainty about the level of returns. The higher the uncertainty the higher the risk. The higher the risk the higher (potentially) the level of return. There are four key elements of investment risk:
- Inflation risk
- Investment risk
- Longevity risk
- Liquidity risk
Each of which we cover below.
Inflation is the rate of increase (over a set period of time) of a basket of goods and services. If inflation increases above the average increase in the value of investments the purchasing power of those investments (cash or assets) falls in real terms.
Holding cash or investing in an asset that is not linked in some way to the rate of inflation gives rise to inflation risk. Investment is a long-term exercise and it is easy to get sucked into a short-term view. In recent years it has been assumed that annual investment growth of 4% would cover the impact of inflation and grow the fund value.
With UK inflation ranging between roughly 0.5 and 2.5% between 2015 and 2018, this assumption has been valid over the short term. However, as recently as 2011 inflation was over 4.5%.
Living for 20 – 25 years after retirement is not an unreasonable expectation. If inflation were to hold at a consistent 2.5% level the purchasing power of today’s pound would be severely depleted in 25 years time.
The price of over 100,000 goods and services are measured each month to calculate the RPI and CPI. They are then weighted and a calculation model applied to arrive at an inflation (percentage) rate. What matters in retirement is not the RPI or CPI but the impact of inflation on the key items where the majority of money is actually spent in retirement.
For example, in retirement, a mortgage may be paid off but the bills still need to be paid. What happens if the price of utilities (electricity, gas, water) consistently increases more than inflation. With no travel to and from work in retirement the price of petrol may be less relevant but what if food prices increase significantly compared to the other items used to calculate inflation.
In any pre-retirement planning exercise one of the key issues to consider is investment risk. It defines the possibility a loss will be made on an investment. The classic small print states “The value of investments could go down as well as up” and that statement should be considered seriously before making any investment decision.
Investment is a possession acquired in the expectation its value will increase over time. The objective is to beat inflation (see above) and create a return. But a bad investment decision could mean a return lower than the actual amount invested. Worse still, choose an investment company that is not covered by the Financial Services Compensation Scheme (FSCS) and if that company fails there is very little chance of recovering any of the investment.
Over a thirty to forty year period of saving for retirement history shows there will be several serious market downturns. Assuming ongoing contributions to the pension pot then downturns are not a major problem during a working lifetime. Investments tend to recover (and more) losses accrued during the downturns. Assuming a major downturn does not occur immediately preceding retirement.
During retirement it is probable contributions to the investment fund will stop and regular withdrawals will be made instead. With no contributions and perhaps limited time to recover downturns can do more harm in retirement than while in work. The situation is compounded if significant withdrawals are made during market downturns. Of course, more risky investments have more chance of a significant downturn.
As discussed above market, political and economic conditions change over time and past performance is not a reliable indicator of the future. Also, tax law can change over time affecting the return on investment. One of the key strategies employed to minimise investment risk is diversification.
In simple terms, longevity risk is the consequences associated with running out of cash and/or assets in retirement leaving the individual at the mercy of whatever state provision may exist at the time. It raises a number of questions to ask when preparing a pre-retirement plan, many of which do not have a definitive answer.
Key questions to ask include how long am I likely to live? What income am I likely to need in retirement? What about any long-term care costs? Is there a way to guarantee a retirement income for life and what are the costs of that guarantee? If I do die before my spouse how much (if any) of my remaining pension fund will he/she receive? If I die relatively young is there any way my beneficiaries can benefit from my remaining pension.
No one can know how long they may live and there is always the temptation to spend today as it may not be possible to spend tomorrow. But the evidence shows we are all living longer. It is estimated between 2015-2020 the percentage of the UK population over 85 years old will increase 18% and will increase further thereafter.
Although understandable, the spend today approach can have major long-term consequences and it is important to identify what those consequences may be. What if cash reserves run out in retirement will any state provision be enough. What about any unexpected expenses. What if long-term care is required.
Liquidity risk arises when it is not possible to sell an asset at the point desired and/or at its true value. Liquidity can affect those approaching retirement and those in retirement in different ways.
For those approaching retirement that are members of a pension fund with more retirees than active members, there can be a liquidity risk. Payments to retirees could exceed contributions leaving a potential short-term funding gap. Managing liquidity is, therefore, a key issue for pension fund managers.
For those in final salary pension schemes if a high proportion decides to transfer out it could also represent a liquidity risk. For those who opt for an annuity at retirement liquidity is not an issue but for those in Drawdown, it can be a real problem.
Care needs to be taken on the nature of investments held in a portfolio and the relative proportion of each of those investments. Certain investments, by their very nature, are not liquid assets. This can be a real problem depending on when those assets need to be cashed in or worse if they need to be realised rapidly to cope with an emergency.
A pre-retirement planning exercise is essential but it can be complex and time-consuming. The consideration of risk and how that risk may be minimised while retaining an appropriate rate of pension fund growth is a key issue. There is also always the risk of major economic changes, that nobody can predict, having a medium to long-term impact on pension funds. It is always sensible to consider the provision of a safety net in any pre-retirement planning exercise.
Should you wish to discuss your pre-retirement plans then do not hesitate to contact us on 0800 043 8341 or email us at firstname.lastname@example.org
The information in this article does not constitute financial or other professional advice. You should not take action on the basis of this article without seeking regulated independent financial advice that addresses your specific circumstances. The purpose of this blog is to provide technical and generic guidance and should not be interpreted as a personal recommendation or advice. Past performance is not necessarily a guide to the future. You may not get back the full amount of your investment.