This change has given a new lease of life to the estate planning market and, along with record transfer values, helped to trigger the deluge of defined benefit (DB) pension transfers we’ve seen in recent years. Such transfers present the opportunity for pension holders to enjoy similar levels of income, more tax-free cash, greater flexibility and the chance to pay less tax in retirement. They also offer the very real possibility that – with careful management – a substantial pension pot could still be available at the end of their lives to pass along to loved ones.
This potential only increases the need for most Britons to talk through their changing requirements with their adviser to ensure their retirement stays on course.
New reality #3: How you manage the ‘big three’ risks will dictate your quality of life in your dotage
The three big risks that every adviser must help their clients to understand are:
- Longevity risk: Namely the risk that they live too long for their pension pot. To counter it, they’ll need to take a view on their likely life expectancy and ensure the level of income they take won’t erode their pension pot.
- Inflation risk: Inflation risk is the secret killer. It suddenly becomes an extremely destructive force when someone reaches retirement and stops making contributions to their pension pot.Clients need to know that if UK inflation runs at the current annual rate of 2.4% it will erode more than 20% from the value of their pension pot in the first 10 years. Scroll forward another decade and very nearly 40% of their pot will have gone in terms of real spending power.
- Sequence of return risk (or pound cost ravaging): This is the increased risk presented by a fall in returns that comes early in a client’s retirement as opposed to later down the line.This will come as news to the average UK retiree because so long as they were in the accumulation phase of their retirement planning, the order in which they got their returns never really mattered.The opposite is true for clients in decumulation; once they start taking income they effectively cement any losses which can cause irrevocable long-term damage to the value of their pension pot.
New reality #4: Sitting in cash is no longer a safe option
Clients need to understand the role cash plays in a decumulation portfolio. For those still in the accumulation phase, cash provides a safe haven from market volatility and valuable liquidity for a portfolio. However, cash soon loses its lustre in decumulation.
This is because with interest rates so low, cash delivers a negative ‘real’ return after inflation and has done so since the early part of 2009. At current levels, UK inflation will eat about a quarter of a cash pension pot in the first decade. However, the real damage comes from using a depreciating asset like cash to fund regular income withdrawals. There is no better way to terminally deplete a pension fund.
By shunning investment risk in favour of cash, a huge swathe of Britons now risk depleting their pension pots long before their new, longer lives come to an end. Indeed, the depletion rate of a cash-only pension pot is so great that simple arithmetic would suggest most Britons in this position would be better served by buying a series of fixed-term annuities with guaranteed maturity values.
New reality #5: Tomorrow won’t look much like today
Thanks to our cognitive biases, humans have a natural tendency to approach situations in the context of their recent experience. This is referred to as recency bias. This can be especially dangerous when it comes to investment for obvious reasons.
For example, right now (September 2018) the US stock market is exploring record highs as the longest bull market in its history continues to play out with its ‘trophy room’ of the world’s best-known tech names doing most of the heavy lifting. The picture is quite different in the UK and Europe, which have mostly traded sideways this year, while emerging markets actually fell into bear market territory early in September after racking up significant returns in the decade since the financial crash.