The Universal Aspiration of Retirees
Arguably, individuals have two central concerns when considering retirement funding:
- Will I be able to live the life I want to in retirement?
- Will I run out of money before I die?
While these questions are often thought of separately, they are of course linked: varying the distributions that are made in retirement will change the date at which the retirement fund is exhausted.
However, investors treat these two questions very differently. The idea of running out of money in retirement is significantly worse than accepting a lower amount of income during retirement. So much so, that investors often overly penalise their lifestyle in retirement to ensure that the risk of running out of money is eliminated.
In the UK, this risk has been mitigated to a large extent by the requirement that UK retirees have some level of guaranteed income before discretionary retirement planning can take place. That system fitted reasonably well in a world where final salary pensions were the norm, but with DC schemes now serving the majority of private sector employees (as much as 69% of such employees in the US), the burden of annuitising that level of income has been unpopular.
Even though annuities have gone a long way to address investors’ need for security in retirement, especially when longevity is generally underestimated by investors, but standard annuity rates have been reducing over the last few years. As standard annuity rates have been falling over the last few years, annuities could be seen as poor value for money. When the low rates are considered, along with the planned changes to pension legislation, it is clear that investors and their advisers will be considering alternatives to annuities when planning retirement options.
New legislation, same challenges
The 2014 UK Budget effectively did away with the annuitisation requirement. That, together with other measures including changes to the tax regime, will mean investors have greater access to their pension assets, and greater flexibility as to how they are managed.
Overall, these changes are a welcome expansion of choice for investors, who have historically been excluded from this culture of choice that we see in a great many other countries around the world – most notably the USA.
Value for money in investment services is particularly important post-retirement. Our research shows that the majority of retirement income is generated as growth earned post-retirement. This is perhaps the reason why the change is potentially so beneficial to investors as more could decide to maintain their exposures to risk-bearing investments and in turn potentially boost their retirement income as a result.
Our research shows that a good rule of thumb is for every £100 of income in retirement, only £10 comes from your initial contributions; £30 comes from investment returns pre-retirement and £60 for investment returns post-retirement (the 10:30:60 rule)[i].
The level at which many investors need to maintain an exposure to risk in order to take advantage of growth during retirement is influenced by investors contributing too little or planning for retirement provision too late.
Our research shows that full-career employees that remain invested throughout retirement need to save 11 times their final salary in order to have an 85% chance of funding retirement without running out of money[ii]. To reach this goal in a diversified portfolio (60%/40% Equity/Bonds), the average savings rate needs to be 12% annually over a 40-year career.
This is complicated by a trend of individuals serially underestimating their longevity. For example, one study from the Society of Actuaries claims 40% of adults aged 45 to 80 underestimated their likely average longevity by five years or more[iii].
Mitigating longevity risk
Given the need to fund longer retirements for individuals who need to get every ounce of value from their savings, what planning approaches are available and what investment strategies can we develop to cater for these approaches?
One way is to combine a drawdown plan over a fixed time period with an additional investment to purchase an immediate lifetime annuity should the end of the drawdown plan be reached, or even an earlier purchase of a deferred income annuity. This approach may mean the investor can benefit from the cross-subsidy effect inherent in annuity funding, but may still be an expensive way to provide income for a limited number of years once the drawdown fund has been depleted.
An alternative approach could be to use an income-paying investment fund which aims to maintain the value of capital while paying out the income from investments. In this way the fund capital remains invested to hedge against longevity with living expenses beyond the state pension taken from the fund income. The capital remains accessible to the investor should it be needed for healthcare costs for example, to become part of the investor’s estate or to be converted into a drawdown portfolio at a future date. It is critical that an investment used in this scenario is low risk and pays as consistent an income as possible.
Russell Investments Multi-Asset Income Fund has been created with the aim of generating a stable level of monthly income while preserving and growing the capital. The key features of the fund are:
- An objective to pay consistent monthly income and maintain and grow capital over time.
- The multi-asset approach results in a fund with a cautious risk profile – more suited to the risk profile of retirees and essential to minimize drawdown which would limit the ability of the investor to fund their lifestyle.
- With diversification across 4 asset classes, 9 sub-asset classes, 28 specialist managers and thousands of individual holdings, the fund has appropriate diversification for a client’s total wealth.
- An ongoing charge of only 1.13% makes it a cost-effective solution.
Improving outcomes for retirees
In a world where annuity rates are low and longevity increasing, financial plans need to be structured to make investments work hard. With legislation changing rapidly, the availability of different types of drawdown strategies to different types of investor is likely to grow. So too are the types of annuity on offer as the industry moves to innovate in the face of declining revenues.
At the same time the appeal of simple yet sophisticated income generating strategies will ensure many investors are able to provide retirement income while retaining control of their assets.
The Multi-Asset Income Fund is one of only a few low cost, monthly distributing multi-manager funds on the market, and it has so far delivered on the expectations we have for it as is illustrated in exhibit 2 below.