‘Spend more money’ is not something you would expect to be advised to do with your retirement assets, but according to a recent study it might be the only antidote to increasing conservatism among retirees.
The Institute for Fiscal Studies (IFS) has found that UK pensioners are not very good at spending their wealth, so often leave significant sums for inheritance, either deliberately or because funds intended for care costs did not get used. Only 31 per cent of wealth was drawn down to support retirement by savers aged between 70 and 90 covered by the IFS study, a significantly lower level than the 75 per cent decline in life expectancy between those ages. The rate of drawdown increases with pensioners' level of wealth, but never to the level where it matches reductions in life expectancy.
The IFS study suggests that retirees are holding on to savings too long and missing out on a better quality of life.
Preserving savings can be logical: many investors, including some of those featured in our Portfolio Clinic, often mention leaving inheritance as a key aim. And having funds to cover the cost of potential care and as insurance is sensible. However, saving and investing diligently but not having as comfortable a retirement as you can afford is not an attractive prospect.
Retirees may not spend as much as they can afford because investors become more conservative as they get older, even if they have substantial assets including property, individual savings accounts (Isas) and pensions. However, it could also be because of confusion over safe withdrawal rates and what the right amount of income to take from a portfolio is, while ensuring that capital is left intact or lasts for the rest of their lives.
The IFS study also found that most homeowners do not use their main residence to support retirement but rather to pass on wealth. Drawdown rates from financial assets held outside pensions are low, suggesting that a key tax-efficient opportunity is being missed.
That's beacuse assets in money-purchase pensions can be passed on to heirs without incurring inheritance tax (IHT), whereas Isas, cash savings, investment accounts and property are included in estates for IHT purposes. If you plan to pass on assets it is generally better to draw from non-pension assets first. The IFS study suggests that tax-inefficiency is common, although the pension IHT rules are relatively new, so it could be too early to have an accurate picture of this situation.
Sophie Kilvert, private client manager at Seven Investment Management, says conservatism is common among retirees and increases with age.
"The ideal situation should be dying with £1 in the bank because you have spent all the money you could possibly spend," she says. "People have a real fear of needing money for care or insurance, and there is a lot of planning around that."
Ms Kilvert says an example of this is as follows. A couple, aged 90 and 80, have investments worth £400,000, and live off the 5 per cent annualised return and income these provide. They don't have children, so have not done any inheritance planning.
"The couple get nervous and anxious when the value of the portfolio drops below £400,000," says Ms Kilvert. "But as they are aged 80 and 90, and have no intention of passing on their wealth, it shouldn't be a problem if it drops below the starting point. There is something psychological that stops people using their money to lead a better and higher quality of life. There is this innate need for insurance, which is fine when you have children or something you want to pass on. But otherwise why are you not spending it? We have been coached to take less risk as we get older. But there is not always a need to do that. Just because you're taking an income does not mean you have to de-risk your investments."
Sustainable drawdown
The complexities involved in drawing down assets correctly to support retirement may contribute to retirees' conservative approach with their savings. There are many things to consider, especially when investments are being used to provide income in retirement. It is difficult to plan how long a retirement pot should last, and having some left over is better than running out of money in your latter years.
But financial modelling can help. And a lot of research has been done on sustainable rates of drawdown from a multi-asset portfolio, where the investors take an annual income from dividends and the sale of assets.
Investment research company Morningstar found that if investors want to be relatively risk averse and have a 99 per cent chance of a 40 per cent equity portfolio lasting for a retirement of 30 years, the safe withdrawal rate could only be 1.8 per cent. The safe withdrawal rate is the percentage of the portfolio annually taken as income.
If investors need more income and are willing to let the probability of a 40 per cent equity portfolio lasting for 30 years fall to 70 per cent, the withdrawal rate rises to 2.9 per cent.
For a 70 per cent chance that a 40 per cent equity portfolio will last for a retirement of 40 years, meanwhile, the withdrawal rate is 2.3 per cent.
Fees also need to be considered. If investors pay fees of 0.5 per cent a year and withdraw 3 per cent a year from a 40 per cent equity portfolio, the chance of it lasting 30 years is 77.6 per cent, according to Morningstar. However, a fee of 1 per cent a year means the probability of it lasting for 30 years falls to 68.1 per cent, and a 2 per cent fee 45.7 per cent.
Morningstar's research, however, focuses on ensuring portfolios last for the length of retirements but, as the IFS study shows, this is not everyone's aim. Many retirees want their assets to provide an annual income and for their value not to fall substantially.
Asset manager Sarasin and Partners has found that investors must be comfortable with exposure to risk assets and understand that the time they enter the market could have a big impact on their returns.
For example, a portfolio that had an 80 per cent allocation to risk assets such as equities and property between 1987 and 2017, from which investors drew 5 per cent a year, would have had the same real value in 2017 as in 1987, after inflation and fees of 0.65 per cent were taken into account, according to Sarasin and Partners.
But a portfolio that had an 80 per cent allocation to risk assets such as equities and property between 1997 and 2017, which suffered the 2000 stock market crash early on, would have only retained its real value if the investors had at most drawn down 3.4 per cent a year.
These examples illustrate that the timing of market cycles can seriously affect the level of safe income investors can take.
Complexities
However, David Butler, strategic accounts director at wealth manager Quilter Cheviot, says historic returns and models suggest that investors should not consider income as a flat line.
"The safe withdrawal rate is dependent on so many different factors, such as the sequence of returns you get in the first 10 years and your life expectancy," he explains. "Thinking of a safe withdrawal rate as something fixed is dangerous and will lead some people to spend too much and some not to spend enough. What you need is a flexible withdrawal rate as people's needs for income change in retirement."
The IFS study highlights this too. Investors covered by its study aged between 79 and 91 only reduced their wealth by 1 per cent over a 12-year period compared with 14 per cent for those aged 69 to 81. So investors should consider adjusting their annual income drawdown depending on the performance of their portfolio, taking more when returns are strong in bull markets, and less when markets are falling. This would also mean more assets are left in their investment portfolios to capture rising markets. Investors could also take more in earlier years, in the expectation that their spending requirements will fall as they get older, with the exception of care costs.
James Hutton, partner at Sarasin and Partners, says this is particularly relevant when creating models based on future returns – what most drawdown models do. This is because future return potential is likely to be significantly lower than what we have seen in the past. Historic returns from UK government bonds and UK equities have been 5.2 per cent and 9.4 per cent a year, but Sarasin and Partners estimates that for the next seven to 10 years this will fall to 1.2 per cent and 6.1 per cent.
Mr Butler adds: "If investors are looking for natural yields as income, where is that going to come from? If you have a portfolio [with 50 per cent in each of bonds and equities] it should yield around 2.75 per cent as things stand. The only way you can have a natural income at the level most people are looking for, of around 4 per cent, is to have a high [risk] equity portfolio. We have to look at a different way of working."
Investors need to be sure of their aims: do they want to leave an inheritance, spend every penny or a bit of both?
They then should consider how much they want to ensure that they meet their aims as this will affect the level of risk they can take. For example, Morningstar's analysis suggests that risk-averse investors who want certainty that their assets will last to the end of their lives should stick to lower withdrawal rates and keep fees low.
Ms Kilvert adds: "The most important thing is to have a plan and idea of where you're going to pull the money from when you need it. Also make sure you're taking any money in a tax-efficient way. Use Isas first, and top up pensions [for inheritance and emergencies] so when you need it, you know it's there."
