InvestmentsSep 28 2016

Retiring is getting more expensive

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Retiring is getting more expensive

How would you answer a client who asks how much income their savings will provide them in retirement? Could you say what pension pot is needed for, say, £20,000 annual income?

The answer to that last one, for a 55-year-old looking to retire in 10 years, is just over £550,000. Or, to put it differently, £27.75 in savings today for each £1 of income in the future. I will explain how we can put such a precise figure on it in a moment. 

First: why is it so important to have an answer to this question? 

For anyone without a defined benefit pension, retirement (in most cases) used to be as simple as shopping around for an annuity. Now, pension savers are faced with all sorts of risks. Longevity risk: will my savings run out before I do? Sequence risk: have I considered how my investments will perform if I withdraw money at a bad time? Investment risk: what happens to my retirement if the stock market crashes?

Savers also have a dizzying array of product options. Rather than selecting from a list of annuities, they can now pick anything from blended products to high-yield bonds to overseas property. All this before we even get to the new issue of tax efficiency and legacy. 

Put simply, individuals are now largely responsible for their own retirement, with all of the choice, risk, and responsibility that involves. And not many know what to do to get the income they want. 

Given all of that complexity surrounding new retirement choices, simple tools can be an excellent way to kick off retirement discussions. The figures above – £550,000 for £20,000 income – come from an interactive online tool developed by BlackRock to help visualise retirement choices. 

It is possible to combine interest rates, inflation and mortality projections, among other factors, to generate an instant estimate of the income a client’s savings may provide in retirement. This helps answer the question “what can I expect when I retire?” and, as it is a lifetime measure, the impossible-to-answer question “how long will I live?” is taken off the table entirely. 

There are obviously plenty of ways to calculate potential retirement income. One way is based on annuity pricing methods. This gives an indication of the income someone could expect if they ‘cashed out’ of their investments and annuitised. Annuity providers are hugely experienced in pricing future income, and using their methodology essentially brings institutional level forecasting to the everyday investor. 

How to use it

1. To get a retirement bearing

A 55-year-old who has saved diligently has a pension pot of £250,000. He currently earns £30,000 a year and he has no idea what portion of that income could be realistically replaced by his savings. It is possible for an adviser to give this client a precise, ‘live’ estimate of what type of income he is on track for.

For example, if his current retirement income level is £27.75, dividing £250,000 by this amount gives an estimated income of £9,009. 

If the client already had a retirement income figure in mind, say £15,000, it would be clear to them what kind of pot they’d need (approximately £415,000) to achieve this goal based on today’s prices. Any gap between their estimated pot size and the amount actually required to have this level of income would naturally lead to discussions around either putting more money to work or getting current contributions to work harder. 

2. As a portfolio planning tool

For this it can be useful to ‘map’ different multi-asset funds to different growth needs. Multi-asset funds have a number of benefits that make them ideal for retirement saving: they are typically lower-risk growth than equities; they aim to reduce volatility; they are often actively managed, which can give savers some peace of mind; and because they were conceived as retirement products, they are often built in an extremely cost-conscious way. 

Using multi-asset funds at the core of a retirement portfolio can give clients a reference point against which to understand more tactical portfolio allocation. If someone has a 60 per cent core weighting to multi asset, a tactical allocation to assets with a punchier risk/return profile will probably be more palatable.

There are also different blends of multi asset, some with clear references to how much equity risk is being taken. Using these again provides a clear and simple reference point for clients that their core holding is clear and consistent but the risk exposure may need to be dialled up from, say, a 60:40 exposure to equities and bonds to an 80:20 fund which is going for more growth.  

Interest rates have been reduced further in the aftermath of Brexit. With the Bank of England lowering rates and long-term bond yields beaten even further down, retirement has become even more expensive to fund.

The tool might show that it needs £27.75 to buy £1 of annual retirement income. 

But as recently as last year, £1 of retirement income would have cost just £19.46. In other words, today’s cost is around 40 per cent higher than nine months ago. The spike post-Brexit shows that this has played a part, according to CoRI figures accurate as of 12 September 2016. 

So while someone who looked only at markets might think that Brexit had no effect, or a positive one, on their portfolio, our analysis shows that the vote to leave the European Union has actually had a significant impact on the cost of future retirement income. Therefore, this is more about keeping a reality check on whether they are making enough contributions – as they draw closer to retirement – and have a clear picture of what kind of income they could expect if they annuitised. Coupled with an intelligent conversation around drawdown options, this can provide the backdrop to a more productive evaluation of retirement income options.

Jeremy Roberts is head of UK retail sales at BlackRock

 

Key Points

Individuals are now largely responsible for their own retirement, with all of the choice, risk, and responsibility that involves.

It is possible to combine interest rates, inflation and mortality projections, among other factors, to generate an instant estimate of income.

This is more about keeping a reality check on whether they are making enough contributions.