Introduction
Risk is an inherent part of wealth-building and wealth-enjoying. As you know by now, risk comes in all kinds of flavours, some of which are specific to different life stages. In this blog series, we’re looking at the risks you’ll face with your money in retirement. This is a long post, but there is a lot of important information, so please bear with me.
What is Risk?
Risk is a horrible word, right. Just four letters, but covers a huge amount of detail and triggers an array of emotions, many of them negative. Experienced wealth-builders have come to associate risk with reward when it comes to investing, but for those in retirement, while that’s still true to a point, the potential downsides of taking risks can loom larger.
I’m guessing that by the time you’ve got to the point of retiring, you’ve become aware of the fact that investments rise and fall. That’s as much part of the investing experience as tomatoes are part of Bolognese sauce. It is impossible to build wealth without some degree of investment risk; it just comes with the territory.
Now in the olden days when I became a financial adviser, it was still very common for retirees to buy annuities with their accumulated pension pots. The best and most succinct way to describe an annuity is a guaranteed income for life.
And that guaranteed nature is a key part of the attraction of annuities. Unfortunately, rates have reduced so much over time that they rarely look attractive to most people, and the pension freedoms of 2015 were another factor in their decline in popularity.
The default view of retirement is that we want to start enjoying the money we’ve been salting away all of our working life. An annuity was a way to finally take the foot off the gas, convert your fund into income and forget about it, because it was guaranteed. You knew it would come in every month and every year, so you could enjoy the fruits of your labour without worrying.
These days far more people enter some kind of flexible drawdown arrangement than buy annuities. The desire to enjoy the money is the same, but the mechanics are vastly different, simply because the money remains invested.
And because of that, you have to remain engaged to a greater degree with your pension pot and the way it is invested. With investment comes risk, as we’ve said and that’s just as true in retirement as it is in the accumulation phase.
Understanding Risk in Retirement
But now that investment risk takes a slightly different form, because it isn’t so much the fact that markets, and hence your investment value, will rise and fall, it’s more the timing of the rises and falls in relation to your need for income that matters.
Sequencing risk is defined in many different ways by different people, but my standard definition is the risk that you need to make a withdrawal from your investments when they are already depressed due to market conditions. It’s the risk that you need to withdraw when your investments are suffering.
So, it’s the combination of the timing of your withdrawals (which you can control, to a point) and the timing of market cycles, which you can’t control. If too many of your withdrawals happen at inopportune times, as far as your investments are concerned, then you will do significant damage to your portfolio’s longevity.
If it were possible only to draw from our investments when they are showing a profit, that would be great. We know that if we could do that, then we’d never run out of money.
More practically though, most folks take some kind of regular income from their portfolio, or don’t hold enough cash so that they then need to draw from their invested monies for ad hoc expenses, which Sod’s law will always come along at the worst time. So what can you do about this?
How to Manage Risk
Well, in the previous blog series, which is based on my podcast conversation with Matthew Yeates of 7IM, he describes how they have built their Retirement Income Service.
We do something similar for our clients at Jacksons Wealth. I call it the Cashflow Ladder, and I’ll explain it quickly for you here, though you should also listen back to episode 8 of Season 16 where I go into this in a bit more detail.
Your starting point is your baseline attitude to investment risk. I suggest you download an app called Beam if you’re on an iPhone (it should be out soon for Android and web users). It’ll give you real insight into not only your risk profile, but also your behavioural tendencies. For the purposes of this quick description, let’s say you come out as a Balanced investor.
The idea of the Cashflow Ladder is that you assess your regular spending needs month-to-month. How much does your lifestyle cost you? Let’s say that it is £2,500 per month or £30,000 per year.
Ideally, you should keep twice that figure on deposit in the bank, or in a cash holding within your investments. So, in this example, that’s £60,000. Now that might seem an insane amount of money to keep in the bank with interest rates as low as they are, but if you think of this as a buffer against you losing money on the invested portion of your portfolio, then it’ll ease the angst a little bit.
In practice though, it probably won’t be quite so much as this, as chances are that you have some secured sources of income, not least the state pension, or pensions from other sources, or rent from buy-to-let properties. If these income sources are largely guaranteed, then it’s the difference between those and your annual expenditure that you want to use for your two year cash buffer calculation.
You should also factor in any large ad hoc expenditure you’re likely to make in the next year or so. So if you have a big holiday planned, or need to change the car, it’s worth having that on hand in cash too. Again, the whole point is you don’t have to fall foul of sequencing risk.
Once you have the next two years of expenditure in cash, you should keep three years’ worth of expenditure requirements in investments which are a notch or two down from your standard risk appetite. So if you’re a Balanced investor, this could be invested in a Moderately Cautious approach.
Then for years five to ten, you should invest according to your risk profile; Balanced in this case. After that, for money you’re unlikely to need to access for at least ten years, you could consider investing a notch or two above your risk profile, figuring that time will help to smooth the higher volatility. The idea is that money moves down the ladder each year nearer to you needing it at the bottom of the ladder (to spend).
Each year, you should assess your income needs for the coming year, plus the state of market and your investments. If you’re in profit, then you can top up your cash at the bottom of the ladder. If not, then you can delay doing that for up to another year, to give the invested portion time to recover.
It isn’t quite as simple as topping up the cash portion from the moderately cautious pot – you will need to consider the makeup of the whole lot and redistribute accordingly. There are quite a few variables here, which you’ll gather from my conversation with Matthew, so I don’t want to labour the point here. Hopefully you get the general idea of the Cashflow Ladder.
Sequencing risk, then, can be mitigated to some extent by cashflow management. I haven’t even touched on the other variable under your control, which is your spending choices.
If you have a particularly bad year in your portfolio, you can also ease the impact of sequencing risk by dialling back your spending for a time, or by not increasing your spending with inflation. If you haven’t already, read Beyond the 4% Rule by previous guest on the show Abraham Okusanya.
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