Retirement planning: an income strategy for old age
There is no single answer to the problem of how to make increasingly inadequate pension savings cover ever-lengthening lives at a time of low investment returns. Having looked at the way a number of countries tackle the issue, we think any solution needs to combine investment income with longevity insurance.
We have been looking into what people from around the world do with their defined contribution savings after they retire. No market has yet found the ideal strategy. The risks and degree of uncertainty involved often lead to conflicting objectives. Last year, we suggested some principles that any investment solution would need to follow to reconcile these conflicts. Having since drawn on the experience of other markets, we now propose an income strategy that combines stable, real growth in early retirement with some sort of longevity insurance in later old age.
In arriving at this solution, we discovered that certain risks and requirements were common to pensioners the world over. Four key areas of uncertainty stood out:
- Investment – the risk of earning less than expected
- Longevity – the risk of living longer than expected
- Inflation – the risk of prices rising faster than expected
- Consumption – the risk of spending more than expected.
Of these risks, the only one where the individual has any direct control is consumption. The relative importance of the other three changes over time. Figure 1 shows the impact of a small change in each of these key variables. Early in retirement, the risk of not achieving sufficient returns is the major worry, as there is still a significant period of time over which to grow the assets. The threat from inflation is also at its highest early on for the same reason: there is a long period of time over which the uncertainty can manifest itself. Longevity risk starts out relatively small, owing to the high probability of survival through the early years. However, this risk grows with age, reflecting the fact that longevity is self-fulfilling, i.e. the probability of reaching 90 is much higher at 89 than at 65.
This insight helps to focus the solution on the appropriate risk at each stage of retirement. When the savings are largest, generating strong real investment returns with limited losses will provide the biggest benefit. As the pensioner ages, and withdraws income from the account, protecting them against the risk of their outliving their savings should be the main focus.
There is a clear gap between what individuals need in their post-retirement solution and what they want. To manage the economic and actuarial risks outlined above, individuals require a solution to provide certain features. Their most basic needs would include flexibility, stable returns, inflation protection and longevity protection (primary criteria). But they are also likely to want predictable income, simplicity, adequacy and legacy benefits (secondary criteria).
Clearly a number of these factors conflict with each other (for example, predictability versus flexibility) and it is therefore difficult to rank them in order of importance. As with many investment decisions for individuals, a balance of factors is likely to be most effective.