According to conventional wisdom, you should undertake financial risk reduction in the years leading up to retirement. This has resulted in the use of funds that gradually reduce risk, such as target-date funds. In this article, I ask whether or not this approach is sensible.
Traditional retirement based on annuities
In the past, retirement planning usually involved growing your nest egg only up to your retirement date. At that point, you’d use your retirement fund to buy an annuity. This would provide you with a guaranteed pension for life.
What if you experienced a major market downturn just before you retired? In that case, tough luck. You’d have less money with which to buy your annuity. So your pension would be lower for the rest of your life. Even if the market later recovered, you wouldn’t benefit. It was because of this risk that financial advisors typically advocated risk reduction leading up to retirement. The idea was to look for growth when you were younger, but more stability as you approach retirement.
The transition between a pre-retirement accumulation phase and a post-retirement annuitisation phase is sudden. It’s like climbing a hill and finding a cliff-edge at the top. You suddenly give up huge assets in return for pension income. In this case, risk reduction certainly makes a lot of sense.
The growing popularity of drawdown
Over the years the financial benefits of annuities have dwindled due to very low interest rates. Instead, it has become increasingly attractive to keep your pension pot invested, and gradually draw it down. This is not without risk. Consistently poor market returns can decimate your pension pot. But imagine you have a choice between a guaranteed £5,000-a-year pension and a £10,000-a-year income with a 95% chance of being sustainable. This is a simplification of the typical choice of course, but illustrates the point. Many people would choose the latter.
Before the UK government introduced pension freedoms, the choice was usually academic. Many people had been forced into buying an annuity. Now every new retiree has the choice. And drawdown is often the rational choice.
Risk reduction and drawdown
What happens if we take a target-date approach to risk when we have no intention of buying an annuity? In this case we don’t give up all our retirement assets for income. Instead we only draw down what we need. This is known as ‘decumulation’.
The transition from a pre-retirement accumulation phase to a post-retirement decumulation phase is less abrupt than to an annuitisation phase. Investing in order to buy an annuity was like climbing a hill and finding a cliff-edge at the top. On the other hand, investing for drawdown is more like climbing a hill and descending it gradually on the other side.
The impact of a market downturn would still have an impact, but not necessarily permanently. If it were to happen just before retirement, you might need to trim your spending until (hopefully) the market recovered. But you wouldn’t necessarily be locked into a lower income for life.
What if you reduced risk leading up to retirement, using a target-date approach? The problem with doing this arises because you’d be staying invested long after retirement, maybe indefinitely. Reducing risk early could mean reduced returns. Because you’d be cashing in your investments later, you should defer reducing your risk until later. And you should do so more gradually and flexibly, being responsive to changing market conditions.
Managing drawdown risk
With drawdown, you need to be prepared to make course corrections, even after retirement, and even then there may be a risk of failure. One of the course corrections you might need to consider is buying an annuity later on in life. As you get older, annuity returns get better. There may come a point when the risk of continued drawdown no longer outweighs the added returns over an annuity.
If you buy an annuity, you’ll probably seek one-off financial advice; but maybe after that you won’t need it any more. If you opt for drawdown, you may well need ongoing periodic advice, since you’re not making a one-off decision for life.
An excellent way to start to get a handle on the right course of action is to use the Intelligent Financial Planning Calculator from EvolveMyRetirement®. Use it to find an optimised strategy based on your personal circumstances.