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Financing retirement

16/08/2023

In the UK, the state pension won’t fully cover most people’s income requirements and some private savings are likely to be needed. In addition, many people won’t want to wait until 67 before giving up full time work.

The PLSA  estimate that to provide even a minimum standard of living in retirement, at least £2,200 extra per year will be needed to supplement a full state pension of £10,600. This minimum figure rises to an additional £12,700 per year if a moderate standard of living is to be achieved.

For those who have built up assets and saved for retirement, this raises the question of how best to access their wealth. Front and foremost for most retirees will be to ensure they can enjoy the best possible standard of living in retirement without their money running out later on. 

Understanding life expectancy

A starting point to answering these questions might be to consider how long retirement is likely to last. To do this, many people will often reflect on how long their parents and other family members lived, or may be influenced by the age reached by friends and acquaintances who have died. Current health may also play a factor.

Unfortunately, this leads to many people underestimating how long retirement might last. This is because they do not always take account of improvements in life expectancy over time and the fact that new medicines can allow people to live with illnesses for longer. 

In addition, as people get older, the age they are likely to reach also increases. This is because other people in their cohort (born in the same year) will have died. These people bring down the average age at death, whilst those who survive are now statistically likely to live longer.

To aid retirees,the ONS provides a handy life expectancy calculator. This shows that a 65 year old man can expect to reach 85, with a 1 in 4 chance of reaching 92. For a 65 year old woman, the corresponding figure is age 87, with a 1 in 4 chance of reaching 94. In all likelihood, those who have built up a reasonable retirement pot can probably expect to live longer than this.

Different shapes of retirement

In retirement planning, the concept of a ‘U-Shaped’ retirement is often used. This is where someone spends more at the start of retirement as they enjoy their additional free time on holidays and going out. Spending then drops as they get older and become less active, before rising sharply towards the end of life, as they need to cover the high costs of care. This creates the shape of a ‘U’ (or perhaps a ‘V’). 

Although this is true of some people, in reality, only a minority of people actually incur the costs of long-term care. For most, spending needs are perhaps more likely to gradually decrease throughout retirement as ‘staying in’ becomes increasingly attractive - more of a ‘\’ shaped retirement. 

Those retiring today will need to consider how their income needs are likely to change over time.

What people did in the past 

In the past, many retirees benefitted from a ‘defined benefit’ or ‘final salary’ pension, which would pay an index linked pension linked to their earnings. For those who did have a money purchase pot, the standard option was to purchase a level lifetime annuity, often using any tax free cash entitlement to pay off any outstanding mortgage.

Over time, most private companies have replaced their workers final salary schemes with money purchase offerings. Today, defined benefit ‘gold plated’ pensions are largely limited to unfunded schemes for those who work in the public sector, such as teachers or those in the NHS.

After 2015, when pension freedoms were introduced, lifetime annuities fell out of favour for those with money purchase pots, with income drawdown or UFPLS becoming the default. In addition, the conditions that caused low annuity rates led to correspondingly high transfer values for those with a defined benefit scheme, which helped increase the popularity of making a DB-DC transfer. 

Together with the introduction of auto-enrolment, there are more people retiring today with a money purchase pot than ever before. These people benefit from more options and flexibility than past retirees, but also less security than many of those who retired in the past. 

Funding retirement today

For those with a money purchase pension, a lifetime annuity is still the only way to provide a guaranteed income for life. However, even with recent improvements in rates, many retirees still do not appear keen to lock themselves into an irreversible decision. 

In addition, most annuities are sold on a level basis, meaning that income won’t keep up with inflation - This may not be an issue where inflation is low and spending needs gradually decrease, although it can be more of a problem if inflation spikes suddenly as happened last year. 

As drawdown has become more popular, Bengen’s 4% rule has risen to prominence in the UK. This suggests 4% as a maximum 'safe' starting withdrawal rate from a portfolio to avoid money running out over a 30 year retirement, with the starting income adjusted for inflation each year. 

However, Bengen’s calculations were based on a 50/50 portfolio of US treasuries and S&P500 stocks and made no allowance for charges. As a rule of thumb, it is simple to understand, but Bengen himself has adjusted the rule several times and it may not necessarily reflect a UK retiree’s investment portfolio or retirement needs. In particular, it is based on a worst case scenario and doesn’t account for income/spending requirements changing through retirement.

The effect of pound-cost averaging (or ravaging) is probably the most important factor influencing what would be a sustainable income withdrawal rate at retirement. This is because a large market fall at the start of retirement will result in funds running out much earlier than in other scenarios. The lower prices following a fall result in more shares or units needing to be sold earlier on to sustain the income, meaning less are held when the market later recovers and grows. One way to mitigate this might be to look for less volatile investments that can reduce or smooth out market fluctuations.

Another option might be to divide funds into separate pots for short, medium and long-term needs, potentially using low risk investments such as gilts or (at slightly higher risk) corporate bonds to cover essential income needs. An alternative here would be a fixed term annuity, which can be set to cover future income requirements – akin to a bond, but tailored to the retiree’s individual requirements and normally benefitting from 100% Financial Services Compensation Scheme (FSCS) protection.

Comment 

Overall, when considering how to fund retirement, there is no single one size solution that will work for all. Different individuals will have varying circumstances, ambitions, risk tolerance and available assets, which is why most people will want help and can benefit from good financial advice.

One area that does work for everyone is ensuring any decisions made are as tax efficient as possible. In this respect, a pension wrapper will usually offer the most tax advantageous way of funding retirement. However, ISA’s, Equity Release and Investment Bonds can also be used to cover the costs of retirement in a tax efficient way.  

Important Information

Please note this is for general information only and is based on LV=’s understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.