Charges and poor returns can seriously reduce the amount of income people have in retirement. Michael Klimes looks at what can be done to help avoid these pitfalls.
- Charges and markets can curtail income at retirement
- But many people do not understand this
- Solutions include higher saving rates, financial education and personal responsibility
When people start to plan for retirement, one of the pressing questions they have is "Will I have enough money when I stop working?" This is a more difficult issue to confront than dreaming about a Caribbean cruise funded by a large pot of savings in the distant future.
The average saver simply does not know how investment charges, longevity and the rate of return can affect their retirement prospects.
A research paper from Grant Thornton called Age of the customer - Product insights - At retirement "Will I die poor?" takes this head on and tries to provide some solutions. Senior manager Sandy Trust (pictured above) who authored the report says: "We wanted some research to influence the at-retirement debate on the various choices open to customers, the risks associated with those choices and also get into what offers value for customers."
The paper looks at how contrasting investment returns, different charges and longevity shape a person's quality of life when they choose an annuity or drawdown solution in old age. To tease out the complexities of the issues, four questions are asked:
1) What is a sustainable level of drawdown - i.e. the level at which your pot is expected to survive you?
2) How does that compare to an annuity over time?
3) How will charges (or higher levels of drawdown) impact the sustainable level of drawdown?
4) What is the risk associated with each strategy i.e. what is the likelihood of adverse scenarios impacting sustainability of your retirement income strategy?
The research assumes the average investment return is 5%-5.5% per annum. With an average inflation rate of 3%, this gives a real return of 2% per annum.
It also assumes a person's life expectancy increases with age. So in drawdown a person aged 65 and expected to live 19 years until age 84 faces a major problem if they survive to 85 and beyond.
The paper also examines how three levels of charges, 0.4%, 0.9% and 1.9% determine how long a person's level of income lasts in drawdown.
It is notable how a pot can be depleted through a combination of high charges, poor investment returns and mismatched retirement strategy. Take drawdown, for example. The paper has two scenarios modelled on two characters, Jean and David, who both go into drawdown at age 65. Jean has a £25,000 salary at retirement and a defined contribution (DC) pot worth £250,000. Meanwhile David has a salary at retirement of £70,000 and DC pot size of £500,000.
What is a sustainable level of drawdown? Grant Thornton finds each 1% increase in charges reduces the duration of the fund by around 10 years. Each 1% increase in the initial amount of money a person takes out reduces the expected duration of the fund by around nine years.
In concrete terms this means a person who withdraws £20,000 from their pot at age 65 with a total charge of 0.9% will have their pot last until age 98. A person who withdraws £25,000 their pot at age 65 with a total charge of 0.9% will have their pot last until age 89.
A person who withdraws £20,000 with a 1.9% charge will see their pot run out when they are aged 92. A person who has just a 0.4% charge will see their pot last until they are aged 102.
Many do not understand how charges and returns can drastically improve or reduce their quality of life at retirement. For Trust the solution has to come from a variety of sources to improve outcomes: "There is no magic bullet to increasing customer engagement - it's a mixture of government (through financial education), workplace pension providers, time - as it becomes more culturally normal to talk about your pension (in Australia the 'super' is barbecue conversation), and also individuals taking responsibility for their own decisions."
However, to focus on just these solutions is to miss a fundamental point about retirement. There has to be a substantial pot size to begin with before anyone can consider their options. "Accumulation is key; if you are not putting enough in the rest is noise. There are a bunch of people currently in auto-enrolment pensions who think they are fine because they have a pension.
"But an 8% contribution rate over a lifetime (20 to 60), on an average salary, with a 6% investment return (so a 3% real return), might get you a pot of £250,000, which really only gives you a subsistence level of income in retirement."
While Grant Thornton might not have all the answers, its paper flags up some issues that people and the industry need to tackle to help shape a better future.
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