Personal Pension  

The importance of an early start

This article is part of
Retirement Freedom and Responsibility - March 2015

Thinking about retirement planning for most people is like sorting out a complex flow chart of the myriad factors shaping your future.

Some of these you have total control over, such as your rate of saving and spending or how much risk you take with your investments. On other factors, you have some degree of control, such as the duration and earnings level of your employment and your own longevity. Finally, there are a range of factors over which you have absolutely no control, such as market returns and policies governing taxation, savings and entitlements. Knowing that a wide range of variables can determine financial security in retirement, understanding retirement spending and planning accordingly is critical.

This leads us to two potential models for structuring a sustainable DIY retirement income stream. The first involves a so-called bucket method shown below. Put your assets into three categories according to time horizon. In the near-term portfolio that you are going to be regularly dipping into for spending, put that money in cash and cash alternatives such as short-term bonds. The medium-term portfolio, where you will want to keep assets that you do not immediately need but likely will draw down, can be invested in slightly higher yielding assets such as dividend-paying equities. The third bucket in the portfolio should be assets that you can afford to leave invested. Reserve this for riskier, higher-return strategies or for longer-dated savings instruments. Such a model can certainly help investors to grow wealth over time while maintaining spending to support their lifestyle. However, it is at best an inexact rule of thumb.

Article continues after advert

A second model for structuring a retirement income, which we would tend to favour, involves a pyramid. Starting from the base of the pyramid, you move up the spectrum of risk and return to the top, as shown in figure 1. The bottom and largest portion of the pyramid comprises your needs – the basic assets that are going to cover your regular expenses. Your sources of income for the bottom of the pyramid come from your state or defined contribution pensions, Isas, short-term bonds or cash savings. Moving on to the middle of the pyramid, this is the part of your wants, comprised of your desires to pursue a lifestyle in retirement, such as travel. Sources of income in the middle of the pyramid tend to come from investments in equities or fixed income. As you reach the top of the pyramid, representing the smallest part, you reach the legacy considerations, where you might be considering assets to leave to your children. This income, unlikely to ever be drawdown for paying expenses, can be sourced from more high-risk investments or structured in trusts.

Structuring a suitable retirement income stream is different for everyone, taking into account a huge amount of personal considerations. So it is important to keep in mind that these models are only rough guidelines – they would not work for all individuals. In fact, the vast majority of people can definitely benefit from seeking some form of advice when planning their retirement income.