In last week’s post, I set out what factors influence your capacity for loss for retirement income:
-how much money you need to withdraw from your retirement savings every month
-the extent to which the withdrawals need to go up every year
-how long you (and your partner) live. You are unlikely to know the exact number of years in advance!
-what the withdrawals are paying for – essential expenditure like council tax and utility bills, or discretionary items, like holidays; or the extent to which the portfolio is funding both
How Much You Need to Withdraw Every Month
It is doubtful that the amount you withdraw will stay the same throughout your retirement.
Much of the academic work which has been carried out has been based on the assumption that the amount you withdraw every month won’t need to change every month.
In the UK, it’s pretty rare for this to be the case, for a few reasons:
-Our guaranteed pensions, like state pensions and final salary pensions, don’t often start on the same day you stop work and the two types of pension rarely begin at the same time. Most people enter retirement as part of a couple, and one partner almost always dies before the other; this doesn’t only affect retirement spending, it also affects the household income – with guaranteed pensions usually reducing on the death of the first spouse.
-Our spending changes over time. Holiday homes are often sold in later retirement, and we all face the risk of an increase in spending in later retirement if we need care.
It’s important to recognise these factors when calculating capacity for loss for retirement income.
The Extent to Which Withdrawals need to go up every year
The simplistic assumption is that withdrawals need to go up every year in line with inflation. This isn’t true!
Studies have shown that retirement spending tends to increase more slowly than inflation, with an increased rate depending on how much of the spending is needed for essential items.
These items tend to increase in line with inflation, while discretionary spending tends to decline in real terms.
How Long You and Your Partner Will Live
It’s reasonably apparent that capacity for loss will increase with age if the value of your retirement savings remains the same. But it’s important to remember that your life expectancy does not reduce by one year for every year you survive.
So, average life expectancy for a 65-year-old man is 21 years, but it is still six years.
Consequently, capacity for loss does not increase in a straight line as you age. But if your retirement savings maintain their value, over time, your capacity for loss will increase.
What is the Money Needed for?
It’s fairly apparent that, if your retirement savings are needed to pay for essential spendings, such as council tax or electricity, capacity for loss will be less than if the savings are necessary for discretionary expenditure, which can be deferred or foregone completely, such as holidays or gifts to your family.
Research has shown that when you can adopt flexible spending rules (see https://icfp.co.uk/how-to-increase-your-retirement-income/ ), you can withdraw more from your retirement savings than if you cannot.
But you can only adopt flexible spending rules when your retirement savings are needed to pay for discretionary expenditure, at least in part.
Now Science is on your Side
Recent developments in the IT world have allowed us to examine vast amounts of data in just a few seconds, and this has enabled us to adopt a scientific approach to capacity for loss for retirement income seekers.
Whereas previously calculations were based on the silly assumption that investment returns will be the same year on year, we can now model a more realistic approach, taking account of past investment returns from the assets you have in your retirement savings portfolios, or realistic, non-linear projections (using a technique called stochastic modelling).
These realistic investment projections can be combined with accurate life expectancy data and can take account of changes in your other income and other expenditure.
We can then look at whether flexible spending rules can be adopted for some or all of your retirement savings.
As you can imagine, it would be impossible to work all of this out on the back of an envelope (unless you had a large envelope and small handwriting).
Or even by using a smart spreadsheet (unless you had an almost infinite amount of time)!
But technology has enabled us to carry out these calculations for you now in just a few minutes. And this means that we can accurately work out how much of your retirement savings you can afford to lose before your standard of living in retirement might be compromised.
And what this means is that we can tell you accurately, and quickly, whether you are prepared to tolerate more risk than you can afford or vice versa.
So we can tell you whether you should reign in your tendency to take a risk or whether you could take more risk than you thought.
In the world of retirement income planning, this is a huge leap forward – and we are proud to be one of the first firms that can help you in this way.
