Modern retirement isn’t a straightforward business.
Our grandparents were sent home from work at 65 or 60, with a guaranteed pension income and a state pension, which would be enough to keep them content in their old age.
Nowadays, our employers can’t force us to retire, guaranteed pensions make up a small part of our retirement income, the state pension date changes every few months, and we rely heavily on investments to fund our outgoings.
And we aren’t old when we retire!
In this post, I’ve set out the risks that specifically apply to retirement. After all, if you know what risks you are facing, you can do something about reducing them.
I haven’t come up with any solutions in this post by the way; you’ll have to read future posts if you want answers!
I haven’t covered the usual risks which apply to investments in this article either– these get enough coverage of their own (and the last few months have given us plenty of examples of what investment risk is about!).
RISK NUMBER ONE: UNDERESTIMATING EXPENDITURE
My clients are probably fed up of me going on about the need to identify and analyse their expenditure, but that’s because it is a particularly important part of any retirement income plan (and, indeed, any financial plan). And it’s often the part which is most neglected.
People are generally pretty good at identifying regular expenditure (the direct debits and standing orders). It’s the irregular, infrequent and variable expenditure that is often difficult to pin down.
And this often results in people underestimating their expenditure in retirement.
So, you will still need to spend money decorating and maintaining your home, and you may need to replace (at least one of) your cars during your thirty years of retirement.
You might still have to pay tax every January too (particularly now that tax isn’t taken off of investment income at source).
The biggest difference between spending in retirement, compared to immediately before retirement, is that you stop saving (there is no point in taking money out of one savings pot only to put it into another, most of the time) and that you don’t spend money on work related items (like commuting and work clothes).
Most people repay their mortgages some years before they stop work, and children don’t tend to conveniently leave home on the day you stop work!
So, it’s unlikely that you will experience a large reduction in your outgoings when you stop work (you may find you spend more on other items).
Once you’ve stopped working, it’s pretty hard to increase your income to make up for the overspending. As a result, the risk of underestimating expenditure is that the spending you forgot about will reduce the amount you have to spend on the pleasurable things (so the tax bill you forgot about might eat into your holiday budget).
RISK NUMBER TWO: INFLATION
We are all aware that prices go up – even though today’s rates of inflation seem pretty tame compared to what we experienced in the 1970s and 1980s.
The mix of goods and services which we use in retirement is very different to the basket used to calculate the official inflation figures, so the inflation rate which we experience will be different to the RPI or CPI we come across in the news.
However, there is a close link between the official figures and the inflation rate for essential or unavoidable expenditure. That’s partly because we are able to control our discretionary expenditure, whereas our essential expenditure is decided for us.
Research suggests that the average expenditure in retirement rises by around 3% per year less than the official RPI (averages are dangerous though – the range of results is wide).
So, high inflation has a similar impact to underestimating expenditure – we get to spend less on nice things.
RISK NUMBER THREE: TAXATION
The taxman has been kind to retirees in recent decades, and, if you are well-advised, you should pay much less tax in retirement than you did when you are working. The cynical might say that this is because pensioners are much more likely to vote in elections, and, as long as this remains the case, the bark of tax risk will be worse than its bite.
But rising tax rates (or reducing tax allowances) would present a significant threat to the spendable income of many pensioners.
Whilst I am not proposing solutions in this post, it makes sense to have a good tax adviser on your side – they should be able to save you tax now, and help you if pensioner taxation starts to rise.
RISK NUMBER FOUR: SEQUENCE RISK
There has probably been more written about sequence risk in the last couple of years than there has been about the other risks put together. It has been the subject of many an academic paper in the last ten years, and the financial services industry has even come up with a catchy name for it – “pound:cost ravaging”.
When you are drawing money out of an investment portfolio, the sequence of returns you experience makes a big difference to the value of your capital over the long term.
So, if you experience good returns in the first decade of retirement, and bad returns in the last decade, you’ll be better off than somebody who experienced bad returns in the first decade, followed by good returns in the last decade. This is a topic I will explore in more detail in future posts.
The good news is that there are a variety of ways of minimising this risk; and, if you take this risk, there are some potential rewards.
Many retirees have taken a large amount of sequence risk over the last ten years (usually without knowing it) and the risk has paid off for them (we call this “sequence reward”). But it’s unlikely that those who are retiring now will enjoy a ten year bull market in the first decade of their retirement.
Whilst there might not be a solution to all of these risks, it’s important to know what risks you are taking before you work out whether you should stop working.
Armed with this information you can make informed choices.
Modern retirement isn’t a straightforward business. Here are 4 retirement risks you need to understand. Share on X