Outliving finances

So, when will your client die then? I'll need the exact date of death please.

OK. I can see that you're going to have to get back to me on that, but if the client is planning to take income from their pension without the use of an annuity, they're going to have to make a reasonably accurate assumption about their date with Mr D.

The list of assumptions that need to be made in order to formulate a robust retirement plan is very long and I won't rehearse it here, except to say that the fundamental blind spot I encounter most when first working with people, is their inability to think meaningfully about their life expectancy.

Of course, most of the assumptions we make when formulating a retirement plan will be wrong. This is why it is prudent to engage in regular planning, rather than just drafting a plan. Nearly all of it will need to be revised as your client moves through their life. Retirement planning is a practice and it should be done regularly and methodically, revising assumptions and goals in the light of actual experience.

Who wants to outlive their money?

No one I've met wants to live longer than their money, but it's a very real prospect for some. Fortunately annuities, like short-sighted politicians, have been around since Roman times and function to allow savers to insure against 'longevity risk'. However a cursory glance at the annuity market suggests that you can in fact put a price on peace of mind.

Rightly or wrongly, annuities over the past decade have increasingly been seen as a poor outcome for pension savers, and since 6 April 2015, we are now in an environment where there is far greater choice when it comes to de-cumulating pension funds; you know, the fun bit.

However with greater choice comes increased complexity. Let's briefly remind ourselves of the options available to most defined contribution pension savers.

• guaranteed income (annuity);

• flexibly - the pension pot stays invested while money is gradually drawn from it; and

• one cash sum - the pension fund is taken in one go.

These options can be mixed and there is of course the often overlooked option to leave the pension pot untouched until a later date. As my nan used to say, 'Just because you can do something doesn't mean you should'.

Savers can usually take up to 25 per cent of a defined contribution pension pot tax free, with the remaining 75 per cent taxed at their marginal rate of income tax.

For those taking the 'flexible' route, there are effectively two options:

1. Take flexible lump sums of cash. The pot remains invested and every time funds are withdrawn, 25 per cent of the amount is tax free and 75 per cent is taxable.

2. Get a flexible income. 25 per cent of the whole pension pot as a single, tax-free cash sum, with the rest being invested to provide taxable income.

Drawdown (as it is often referred to) is a complex retirement income option, and each individual has their own set of circumstances and requirements. For our purposes, let's take a brief look at a key investment consideration that may crop up.

Volatility drag and sequencing risk

Approaching the de-cumulation of an investment in the same way as accumulation can have potentially disadvantageous consequences. The two concepts that are relevant here are 'volatility drag' and 'sequencing risk'.

If I have £100 and I then lose 20 per cent of it, I now have £80. I now need to make up 25 per cent to get back to where I started. This is volatility drag in action. When regular withdrawals are taken from an investment, the short term periods of losses are compounded very quickly, and are very difficult to recover from.

Sequencing risk is just the flip side of the same coin. It does not affect our client until they are withdrawing money on a regular basis. While accumulating funds, it does not matter if negative returns occur early or late; our client still gets the same account balance over time.

But when de-cumulating, it does matter because selling periodically is necessary to support the required cash flow, and if the negative returns occur first, our client will have significantly reduced the holdings available to participate in the later-occurring positive returns.

It is worth emphasizing the point that prudent investment is rarely about outperforming markets, but setting well defined goals and regularly measuring performance against those goals.

Some investors may have the luxury of taking less out of their investment pot during periods of negative returns to avoid the impact of sequencing risk.

However this might prove more difficult to countenance for those that need a regular and stable income. Perhaps the annuity route will find favour after all.

Steven Hennessy is a chartered financial planner and associate director at Myers Davison Ginger

He writes a regular blog about behavioural finance for Private Client Adviser

@stevethecfp

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