Making pensions last as long as clients

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Making pensions last as long as clients

Sitting next to Steve Bee, my ex-colleague and the original pension guru, I was reminded of a short story by Somerset Maugham entitled The Lotus Eater. I had originally read it at his suggestion and found it to be the perfect illustration of the problem facing retirees from DC pension schemes – how to make your money last exactly as long as you do.

On the face of it, all that needs to be done is to calculate how long a person will live, then divide the value of their pension pot by this amount. This is exactly what Thomas Wilson does in the story. The problem is he got the first bit wrong. Having decided he would live for exactly 25 years, he then found that he was still alive after that and wanted to remain so. As a result he found himself with no money and entirely dependent on the charity of others. 

This might seem extreme, but the reality is that many people plunge into retirement without any clear idea of how much income they can take from their pension plan without running out too soon. 

Key points

  • The average life expectancy at the age of 65 is 21 years for men and 23 years for women.
  • Most clients will live longer than that due to their wealth and lifestyle.
  • A pension fund of £250,000 might look huge to most people, but looks a lot smaller if it is spread over 30 years.

How can advisers solve this problem, other than by persuading clients to be more resolute than Mr Wilson and putting an end to their existence at exactly the right time?

The answer is, of course, that we cannot. We cannot be sure when they will die, and we cannot be sure what will happen during the period between retirement and death. We can, however, make some fairly good estimates, which can make it considerably more likely that our clients will get closer to their target than poor Mr Wilson.

1. Estimate  life expectancy

Recent ONS figures show that the rate of improvement in life expectancy is slowing, but it is still improving. That is good news in any other circumstance than when your pension is running out.

The average life expectancy at the age of 65 – still the most common age at which people start to take benefits – is 21 years for men and 23 years for women. But this is an average, a statistical concept and not a reflection of any real person.

By definition, about half of the people who reach age 65 this year will live longer than the average and about half will not survive as long. You cannot be sure which group any client will fall into. However, there are factors that can help you to make a reasonable estimate.

Longevity is strongly linked to lifestyle, health and wealth. Financial advisers dealing with retiring clients should consider that they are more likely to be in the longer-lived group simply because they are clients and therefore likely to have more wealth and, hence, health and a good lifestyle. Unless there is a good reason to the contrary, such as pre-existing medical conditions or strong familial factors, it is safer to plan on the basis that a client will live longer than the current average. For a 65-year-old in good health a 30-year time horizon is not at all unlikely.

2. Distribute asset value across longevity

Having taken a view on life expectancy it is possible to create a picture of how much income it is feasible for a client to take without it running out. This is a vital part of the process, particularly since the Government Actuary's Department (Gad) income limits were abolished in 2015.

I am a huge advocate of cashflow modelling. Not any particular modeller, but the process. This is because I believe it is essential to show clients how their income will be affected by spreading their fund over several years. A pension fund value of £250,000 might look like a huge amount of money to most people, but it looks a lot smaller if it is spread over 30 years.

Cashflow modelling also allows you to factor in known expenses and answer common questions such as: what happens if I retire earlier? Can I afford to spend more in the early years? When will my income run out? 

It might only be an estimate, but it provides much more realism than simply expecting the fund to run down gradually. People’s lives do not run smoothly and their spending habits will change as they age and as they experience different life events.

3. Set an investment strategy

Another key variable that must be factored into cashflow modelling is the performance of the underlying investments, so the next step is to set an investment strategy and analyse how clients' assets are likely to perform in practice. Consideration must be given for short-term cash and income requirements. This will likely be held in lower risk/return assets to mitigate sequencing risk, with any balance invested across a range of funds and assets to match a client’s attitude to investment risk, investment term and level of dependency on their pension in relation to other assets.

Quite simply, everyone’s needs will be different and hence their investment strategy and cashflow models should reflect that.

The cashflow model is more effective where it can include all of the client’s sources of income in retirement and use different growth assumptions where appropriate. Furthermore, the model can be used to illustrate their vulnerability to unplanned events such as a market crash.

Pulling all of this together, Chart A shows how a client’s income needs may be met using the different income sources available to them (figures are adjusted for inflation). 

4. Consider longevity insurance

Ultimately, the best way to ensure money does not run out while the client is still alive is to purchase longevity insurance, the most common form of which is still an annuity purchase. Unfortunately, the well-documented fall in annuity rates, together with their relative inflexibility, means they are less suitable for young retirees. There comes a point though for most people where this situation changes. Then the advantages of security outweigh the disadvantage of uncertainty. 

Many advisers still use age 75 as a benchmark for annuity purchase at outset.

There are good reasons –  the effect of mortality drag and improved predictability of spending. However, as the client ages, a more individual approach should be taken. In most cases annuity purchase should be phased across several years, capturing investment gains and consolidating these into a secured income for life, progressively increasing the longevity assurance while still retaining some flexibility and scope for further investment growth.

5. Revise the plan over time

Cashflow models are necessarily built on assumptions made at a single point in time and as such are unlikely to be mirrored by the client’s actual experience. As a result the most essential part of ensuring clients do not run out of money is to keep reviewing the model and take action when things change.

This could mean having to accept a cut in income for a while or, more happily, taking advantage of greater than expected growth on the funds. An ongoing review service is not just an exercise, it is a vital component of post-retirement advice.

Summary

  • Consider the life expectancy of your client. Unless there is a reason to think otherwise assume they will exceed average life expectancy.
  • Carry out a cashflow analysis of how the client’s funds can be paid to them over this period.
  • Consider at what point to introduce longevity insurance.
  • Review the situation on a regular basis to take into account what has actually happened in the client’s life and investment markets.

Fiona Tait is technical director of Intelligent Pensions