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On retirement uncertainties

Many of us face several uncertainties in retirement. There is something we can do about this, and more that governments can do.
January 16, 2020

Another new year, and I’m still at work. This reflects a problem that millions of us have, and will continue to have – that retirement is now a much more uncertain prospect than it used to be.

Years ago, those of us in good jobs could look forward to a final-salary-based pension that would protect us from inflation. We had security, if not great wealth, for the rest of our lives. Those with reasonable wealth who didn’t have this could achieve the same thing by buying an annuity at a decent rate. And even those who didn’t do this had a good guide on how to run down their wealth: the 'rule of 4 per cent' told us we could spend 4 per cent of our wealth each year in the reasonable hope of maintaining our capital intact.

Today, we have no such certainty. Fewer of us have final-salary pensions, annuity rates are pitiful, and we cannot rely on the rule of 4 per cent. For this to work, returns on financial assets must be sufficiently high to make up for us spending some of our wealth. But how can this be the case when returns on cash and gilts are nugatory? It can only be if there is a large equity risk premium. But risks sometimes materialise. And if they do, the 4 per cent rule will go out the window. It will only work if the future resembles the past. But we cannot be sure of this. Instead, we face what Richard Bookstaber, the author of The End of Theory, calls radical uncertainty.

Uncertainty about longer-term returns, however, is not the only uncertainty we face.

There’s also longevity risk: how long will we live?

And then there’s uncertainty about how much we’ll spend in retirement. Yes, most of us can cut some work-related expenses. But for me, if I have more time on my hands I might well spend more on holidays, music, days out and books. And for most of us there’s uncertainty about whether we’ll need to buy expensive social care, and if so for how long.

In many ways, then, retirement today is a leap in the dark in a way it was not for those people a decade or so older than us.

So, what can we do to cope with all these uncertainties?

The fact you are reading this gives you one answer: I’m working longer. And I’m not alone. In the past five years the numbers of 50-64 year-olds in work have risen by over a million, or 14.2 per cent. And the numbers of over-65s in work have doubled since the early 2000s.

Working is a call option on retiring. And the value of any option increases as uncertainty rises. So I’m clinging onto it.

Another thing I can do is to run down my wealth. Even those of you who’d like to leave a bequest have, however, some flexibility here. If you let your wealth rather than your spending fall in a bear market you are in effect pooling equity risk with your children and grandchildren. And if they are in work – or about to enter it – they will be better able to bear such risk than you are. A flexible bequest plan is therefore a form of insurance.

And then I have two other options later in life. I could buy an annuity, or release some of the equity in my house. Neither of these are great value now. But they might become so – or I might get desperate.

But are all these solutions sufficient?

Here, I run into a problem. Wishful thinking is widespread and it distorts our financial decision-making in all sorts of ways. It might be colouring my approach to retirement: I imagine an old age that is both affluent(ish) and a little like Anthony Burgess’s Kenneth Toomey’s.

On the other hand, though, there’s also a danger in over-correcting this bias and becoming too gloomy, which might cause me to work too long. It is only by accident that I, or anybody else, can steer the correct middle course here.

In principle, though, the solution to retirement uncertainty should not lie only in our own individual hands. There is much that the government could do.

One thing would be to change the macroeconomic policy mix in favour of a looser fiscal and tighter monetary policy. This would raise gilt yields and hence annuity rates.

Another thing would be to provide some sort of insurance against expensive social care.

Yet another solution would be a higher state pension. This is a way of pooling risk: aggregate longevity is more predictable than individual. And because tax revenue is less volatile than investment returns, the state is better able to bear risk than individuals. Former chancellor George Osborne is to be applauded for introducing the triple lock, which in effect ensures that the state pension will gradually rise over time: the idea that this is unaffordable is obvious nonsense.

One of the fundamental questions in economic policy is: what tasks should be done by individuals, and what by the state? This question has not always been answered correctly in recent years.