For those nearing retirement, a pre-retirement planning exercise is essential to identify the best way to access pension funds and ensure those funds deliver the type of retirement you have always aspired to. One of the issues to consider when preparing a retirement plan is risk.
Before discussing risk in detail some basic definitions. Inflation is the rate of increase (over a set period of time) of a basket of goods and services. Investment is a possession acquired in the expectation its value will increase over time.
The price of over 100,000 goods and services are measured each month. They are then weighted and a calculation model applied to arrive at an inflation (percentage) rate. Holding cash or investing in an asset that is not linked in some way to the rate of inflation gives rise to inflation risk. 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.
Investment is a long-term exercise and it is easy to get sucked into a short-term view. UK inflation may have been consistently under 0.5% from early 2015 to date but as recently as 2011 it was over 4.5%. It may be assumed that if an investment rises in value by 4% year on year then that is adequate before Brexit most UK economists expected inflation to reach a maximum 2.5% in the short to medium term. The position now, particularly in the medium term, is more uncertain.
In any pre-retirement planning exercise one of the key issues to consider investment risk. 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. Investments are made to beat inflation (see above) and ideally 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 firm stops trading or becomes insolvent there is very little chance of recovering investments made.
As discussed above market, political and economic conditions change over time therefore past performance is not a reliable indicator of what may happen in future. Also, tax law can change over time affecting the return on investment. As an example, the recent stamp duty change on second homes made a property a less attractive investment for some.
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.
We are all living longer. It is estimated during the period 2015-2020 the percentage of the UK population over 85 years old will increase 18% and will increase further thereafter. Therefore living for 20 – 25 years after retirement in not an unreasonable expectation. Inflation (as stated above) is a major risk. If inflation were to hold at a 2.5% level the purchasing power of today’s pound would be severely depleted in 25 years time.
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. Although understandable, that approach can have major long-term consequences and it is important to identify what those consequences may be. 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 therefore always sensible to consider the provision of a safety net in any pre-retirement planning exercise.
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 as 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, which can be a real problem depending on when those assets need to be realised 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 to fund retirement is a key issue. Should you wish to discuss your pre-retirement plans then do not hesitate to contact us on 0800 043 8341 or email us at email@example.com
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.