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.<\/p>\n
In the past, retirement planning usually involved growing your nest egg only up to your retirement date. At that point, you\u2019d use your retirement fund to buy an annuity. This would provide you with a guaranteed pension for life.<\/p>\n
What if you experienced a major market downturn just before you retired? In that case, tough luck. You\u2019d 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\u2019t 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.<\/p>\n
The transition between a pre-retirement accumulation phase and a post-retirement annuitisation phase is sudden. It\u2019s 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.<\/p>\n
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 \u00a35,000-a-year pension and a \u00a310,000-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.<\/p>\n
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.<\/p>\n
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\u2019t give up all our retirement assets for income. Instead we only draw down what we need. This is known as \u2018decumulation\u2019.<\/p>\n
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.<\/p>\n