Over the last decade, two distinct philosophies have developed in retirement income planning:
Safety First. This is the original, old school way of planning your retirement income. Rather than managing your investments to provide an income, you give them to an insurance company, in exchange for a guaranteed income for the rest of your life.
Probability-Based. This approach has gained ground over the last 30 years, helped by the academic research and developments in technology. You manage your investments to provide an income in the form of regular withdrawals from your portfolio for the rest of your life, taking account of the probability that the income level you need will be sustainable for the rest of your life.
Advocates of the two schools view retirement income planning very differently. They provide differing answers for basic questions such as:
-What is the best way to approach investing financial assets for retirement income?
-Is there a sustainable spending rate from a portfolio of investments?
-What role should annuities and guaranteed income plans play in a retirement income strategy?
In the UK, over the last twenty or thirty years, the Safety First Approach has been steadily losing ground.
Increasing longevity has increased risk (the longer you live, the more chance there is that something will go wrong!), so, in theory, the Safety First approach should have become more attractive.
But many people have a natural aversion to annuities (see https://icfp.co.uk/why-we-dont-always-like-annuities/) and the reduction in annuity rates over the last thirty years has driven people towards Probability-Based solutions.
Government pension policy has swung from Safety First to Probability-Based, starting with the removal of compulsory annuity purchase at retirement, and concluding with the Pension Freedoms introduced in April 2015.
Most of us are still forced to rely, at least in part, on the Safety First approach. The state pension is the ultimate Safety First solution, and the government isn’t about to offer a cash alternative to those in the Probability-Based camp.
There is a straightforward way to decide which approach is right for you, with recent software developments allowing us to predict the chance that your retirement fund will be exhausted during your lifetime if you use the probability-based approach.
Imagine, for example, that we calculate that there is a 90% chance that your retirement savings will not run out during your lifetime if you withdraw a certain amount from them every year.
-For probability-based thinkers, 90% success is a more than reasonable starting point. They feel that it is likely that their plan will work. If future reviews determine that the plan might be on course toward failure, a few changes, such as a small reduction in spending, should be sufficient to get the plan back on track.
-Those in the safety-first school, however, will not be comfortable with this level of risk, focusing instead on the 10% chance of failure.
Many people believe that one approach is right, and the other is wrong and will argue their case. Providers of annuities will always advocate a safety-first approach, while investment companies will always favour a probability-based solution.
There is an old saying that if the only tool you have is a hammer, then everything starts to look like a nail!
Most of us are practical, not dogmatic, and a combination of the two approaches will provide the best solution. However, it’s essential to choose an approach which suits you, and which you will remain comfortable with throughout your retirement.
A good retirement income planner will be able to set out the pros and cons of both approaches and let you make an informed choice about the combination that is right for you.
