In April 2015 pension legislation was introduced that permitted retirees with defined contribution (DC) pensions to access them in a more flexible way, writes Justin Rourke, of Armstrong Watson Financial Planning.
Prior to this, the vast majority of retirees would exchange their pensions (after taking the 25% tax-free cash) for a guaranteed income for life, an annuity.
Flexible Access Drawdown (FAD)
Whilst an annuity is still a valuable option for many retirees, the last decade has seen many more people opt for a flexible income called flexible access drawdown (FAD).
With the added flexibility comes added risks, and types of risk that investors have not formerly been accustomed to as they have previously been accumulating investments and/or pensions.
Sequencing risk
When planning for retirement, it’s crucial to understand sequencing risk and how to manage it effectively.
This refers to the risk that the order, and timing, of your investment returns could negatively impact your retirement savings. It is important to note that this potential risk is particularly significant during the decumulation phase, when you start withdrawing money from your retirement fund.
For example, if you retire and begin withdrawing from your savings, and the market takes a downturn early in your retirement, your savings could be significantly reduced, making it harder to recover even if the market improves later. This is sequencing risk in action.
In March 2024 the Financial Conduct Authority (FCA) published their thematic review on ‘retirement income’, acknowledging the need for appropriate advice and strategies to be in place.
Why is a decumulation strategy important?
- Longevity risk: People are living longer, which means your retirement savings need to last longer. A well-planned decumulation strategy helps ensure you don’t outlive your savings.
- Market volatility: The value of your investments may fluctuate due to market conditions. A decumulation strategy can help mitigate the impact of market downturns on your retirement income.
- Inflation: Over time, the cost of living increases. Your decumulation strategy should account for inflation to maintain your purchasing power.
- Spending needs: Your spending needs may change throughout retirement. A flexible decumulation strategy can adapt to these changes, ensuring you have enough money when you need it.
Key components of a pension decumulation strategy
- Diversification: Spread your investments across different asset classes (stocks, bonds, etc.) to reduce risk.
- Withdrawal rate: Determine a sustainable withdrawal rate. The 4% rule is a common guideline, suggesting you withdraw 4% of your savings annually, although this may not be suitable for everyone and advice should be sought annually.
- Buffer assets: Keep some savings in less volatile assets, like cash or bonds, to draw from during market downturns.
- Annuities: Consider purchasing an annuity for guaranteed income. Annuities can provide a steady stream of income for life.
- Regular reviews: Regularly review and adjust your strategy based on market conditions and your spending needs.
By understanding and implementing a decumulation strategy, you can help ensure your retirement savings last and provide the income you need throughout your retirement.
Armstrong Watson Financial Planning in conjunction with the Armstrong Watson Investment Committee has designed and implemented a process to guide you into and throughout this phase of your financial planning.
This includes reviewing your risk profile under the lens of decumulation, looking at scenarios that may impact negatively on your retirement income, and providing you with a range of investment solutions specifically suited for when you are taking income or making regular withdrawals.
There are a number of theories around retirement income, including the 4% rule, the bucket strategy – dividing your investments into short, medium and long-term buckets that will fund your lifestyle at different points in retirement – and fixed percentage withdrawals.
Our philosophy is to assess your needs and circumstances and build a tailored approach to meet your objectives whilst reviewing them on a regular basis.
