Most retirement planning advice focuses on the accumulation phase – how big a pension pot you need, where and how to invest, or how much you should save each month. However, there is also the decumulation phase, when you start to rely on your savings to finance part or all of your living costs. Savers (and advisers) often underestimate its importance and complexity.
Clear Objectives But Many Unknowns
There are two main objectives in the decumulation phase:
- Make sure you don’t outlive your savings.
- Enjoy the best quality of life possible.
Although these sound fairly simple, there are many uncertainties complicating your decisions.
Firstly, you don’t know how long you will live. This is called longevity risk.
Secondly, you don’t know how much income you will need in future years due to unpredictable inflation and lifestyle changes. For instance, you will probably spend less on travel or hobbies in older age, but the cost of healthcare may go up.
Last but not least, the remaining part of your savings will continue to be invested and therefore subject to market risk (and don’t forget currency risk, especially if you plan to retire overseas).
Key Questions to Ask (Yourself or Your Adviser)
With the above mentioned objectives and risks in mind, decumulation planning involves particularly the following decisions.
How much can you draw from your savings every month or every year?
The popular rule of thumb says that if you withdraw no more than 4% of your retirement savings in any individual year, you won’t run out of money before you die. Unfortunately, this rule ignores all the above listed risks (longevity, inflation and investment risk) and comes with assumptions which may be questionable in today’s world, when an increasing number of people live well into their 90’s, when interest rates are near zero and your portfolio is far from guaranteed to beat inflation, regardless of your investment strategy. Simple universal rules like this one can be taken as rough guidance or starting point, but you should never rely on them blindly and always consider your personal situation.
If you have multiple assets or accounts, which ones should you use first and which ones should you leave for further growth?
Most people retire with a number of different assets or savings vehicles, such as pensions, ISAs, stocks, mutual funds, savings accounts or property. Besides different risk and return profiles, these assets are also subject to different tax treatment or different rules with respect to inheritance. When deciding which ones to use for income now, consider not only the taxes payable in the current tax year, but also your future tax liabilities. Remember that tax allowances such as the Personal Allowance or the CGT Allowance can still be used in retirement.
What is the optimum asset allocation and investment strategy?
While the general recommendation is to make your portfolio more conservative than during your working life (due to shorter time horizon), there are no universal rules. Keep at least a portion of your wealth in very conservative instruments like short-term government bonds and even cash. These should cover at least your basic income needs for the next few years. At the same time, a part of your portfolio should remain invested in assets like stocks or high-yield bonds to allow further growth. Within your equity subportfolio, you may want to increase the weights of low beta or high dividend stocks to keep risk under control and boost income.
The exact weights and securities to choose depend on market situation as well as your personal circumstances – particularly your wealth and other assets you hold. In general, the poorer you are, the more conservative you should be, and vice-versa – if you have other assets to possibly use for income if some of your investments go wrong, you can afford more risk in your portfolio.
Should you buy an annuity?
Even with the new pension freedoms, buying an annuity is still an attractive option to many. When making the decision, treat it as a very conservative component of your portfolio. Its main purpose is to cover your essential income needs and to protect you from the already mentioned risks (longevity, market risk and – with some annuity types – inflation risk). Of course, this protection comes at a cost. Again, if you are wealthier and have other assets to use as potential reserves, you may not need an annuity at all.
One important thing to keep in mind is that decumulation planning does not start on the day when you retire. The two phases – accumulation and decumulation – are not isolated. Decisions made and actions taken during your working life can make your options wider and generally better in retirement.