In Part 1 of our blog on “Retiring from a Group Company Pension Scheme” we looked at determining your income requirement in retirement and at establishing the sources of this income. We also looked at the various lump sum options and the taxation treatment of income for those over age 65.
Next we need to look at how investment returns will affect your income over retirement and the risks to this income.
There are risks inherent in every retirement plan., no matter what efforts you make to mitigate against them. Understanding the risks, and how they will affect your income throughout retirement is crucial. If you are risk averse and think that you are taking on no risk, by perhaps holding your funds in cash, you need to understand that this is not the case – you are just taking on different risks.
So what are some of these risks?
While we have rising life expectancies which is undoubtedly good news, this means you will hopefully be in retirement for a long time. A male reaching age 66 has a life expectancy of 17 years; and some 3 years longer for females. Statistically speaking 50% of people will live longer than this. So, it is essential that you consider carefully the risk of outliving the money you set aside for retirement.
You can think of inflation like an acorn. It starts out small, but given enough time can turn in to a mighty oak tree! A seemingly small inflation rate of say 3% will erode the value of savings or the purchasing power of your income by almost 40% over 20 years. The impact is significant over time and the only antidote to inflation is investing in growth or ‘real’ assets like equities, property or bonds, that aim to provide a return on the member’s capital in excess of inflation.
It is essential that you understand how much ‘risk’ you need to take to meet your income goals. This helps understand the trade-offs of investing and the potential consequences of your decision.
Understanding the risk of not achieving the expected return and how it might impact on your income in retirement is critical to making sure that you can enjoy retirement without running out of money; but equally that you are not afraid to draw down the level of income you need to enjoy the lifestyle you want in retirement.
Even when the expected annual return is achieved, how the return is achieved over time is a risk. An example of this is the risk of a poor sequence of returns and how it can influence retirement out comes.
Where you are exposed to real assets with the potential for growth, there is a risk that the value of the fund will fall. If the portfolio is well diversified and the asset allocation is right for your risk profile, this should be a cyclical loss and the assets should recover their value. But a permanent loss can be crystallised if you need to draw income from the fund at the wrong time. The fund will have to perform that much better in future in order to recover that loss.
Where you are taking regular income withdrawals form the fund the order of ‘good’ and ‘bad’ years of returns really matters.
Looking at an example of a member retiring with €350K, taking income of €20K a year and assuming an average return of 3.6% per annum.
If the return is linear, i.e. 3.6% return each year, the ARF runs out at age 92 (orange line).
If the member has a ‘good’ sequence of returns in the early years, the ARF runs out at age 96 (blue line).
But reverse the sequence of returns and the ARF runs out at age 84 (yellow line).
Source: BNY Mellon
All 3 scenarios have the same average rate of return but very difference outcomes so it is clear that a big part of retirement planning is planning for your income drawdown.
When you are retiring from a group pension scheme you should plan to be in retirement for 20+ years. Over that time your income requirements will change; your investment returns may be different each year and your appetite for risk may change. What won’t change is the need to have a financial plan in retirement and to regularly review it.
Our role as financial planners is to work with you to make sure you have clarity about the level of income you can expect in retirement, confidence that it is achievable in the long term and direction as to how it will be achieved.
If you are retiring from a company pension scheme and would like to find out more about how we work with members, call us on 01 2375500 or email email@example.com.
This material is not intended to provide advice and is provided for general information purposes only.
The legislative information contained herein is based on Harvest Financial Services Limited’s understanding of current practice as at August 2020 and may be subject to change in the future.