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You are a long time retired!

By 22nd February 2018 No Comments

You are a long time retired!

Thirty years ago, securing an income in retirement was relatively simple; accrue years of service in the company’s pension plan and retire on a specific percentage of your final salary.  Today, for most of us, the risk and financial burden of securing an income in retirement has shifted from companies and governments to individuals.

Turning investment assets into a stable income that will support your expenditure throughout the unknown length of your retirement is a challenge.  There are no easy solutions, as markets do not deliver consistent returns and the sequence in which these returns are experienced matter.

The sequence in which returns occur matters when taking an income

Let’s look at the impact of the sequence of returns in two scenarios:

  1. £1,000 lump sum pot that has no additions or withdrawals.
  1. £1,000 pot from which a withdrawal of £100 is made each year.

We will use the following 10-year hypothetical series of annual returns (Table 1), which delivers an annualised return of 4%, whether experienced ‘forward’ or in ‘reverse’.

Table 1: 10 years of hypothetical annual returns – forward and reversed sequences

Year 1 2 3 4 5 6 7 8 9 10
Forward 15% 17% 22% 10% -4% 10% -3% 7% -10% -17%
Reverse -17% -10% 7% -3% 10% -4% 10% 22% 17% 15%

Scenario 1 – A £1,000 lump sum pot and no additions or withdrawals

It makes no difference, in the end, because 1 X 2 X 3 (‘Forward’) is the same as 3 X 2 X 1 (‘Reverse’), as the table below demonstrates.

Table 2: Scenario 1 – A £1,000 lump sum pot and no additions or withdrawals

Year end 1 2 3 4 5 6 7 8 9 10
Forward £1,150 £1,346 £1,642 £1,806 £1,733 £1,907 £1,850 £1,979 £1,781 £1,478
Reverse £830 £747 £799 £775 £853 £819 £901 £1,099 £1,286 £1,478

As soon as money flows into or out of the pot, the sequence in which returns are experienced has a material impact on outcomes, as we can see below.

Table 3: Scenario 2 – A £1,000 pot and £100 is withdrawn each subsequent year

Year 1 2 3 4 5 6 7 8 9 10
Forward £1,150 £1,229 £1,377 £1,404 £1,252 £1,267 £1,132 £1,105 £904 £668
Reverse £830 £657 £596 £481 £419 £306 £227 £155 £64 £0

This scenario equates to taking an income in retirement.  Even though the return sequences both deliver the same outcome on a portfolio with no cash flows, in a withdrawal scenario, weak returns and withdrawals in the early years (‘Reverse’) deplete the portfolio substantially, and when the better returns come in later years, these returns are applied to a far smaller portfolio balance.

The result, in this case, is a poor retirement for those experiencing the ‘Reverse’ sequence. Whilst, withdrawing £100 (or 10% of the starting balance) is unrealistically high, the point is made.

The sequence of returns matters, and upfront and ongoing financial planning is essential.

The value of retirement advice

It is evident that many people who are near, at or in retirement need to take advice from a well-qualified and experienced financial planner.  Advice relating to a transfer from a final salary scheme, buying an annuity or arranging a pension withdrawal strategy are all highly complex.  Tax and regulation make an already complex issue, even more challenging.

Financial modelling your circumstances and evaluating and understanding your requirement for income certainty is key.  Building a suitable portfolio and withdrawal strategy, perhaps encompassing some strategies for dealing with poor market outcomes, is the next critical step.  This is not a set and forget procedure as an insightful discussion on the progress of the pension withdrawal strategy is needed on an annual basis.

Recognising and understanding the possible challenges ahead and dealing with them before they become problematical is central to success.  In most cases these events won’t arise but if they do, that is when a good financial planner will earn his or her weight in gold.

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.