Managing your Income in Retirement
Friday 20 May, 2016
Daniel Stansall, Lonsdale Service’s Independent Financial Adviser in Barnet recommends Lifetime Financial Planning.
Following the recent government changes to how individuals can access their pensions, the question of how best to manage your income in retirement has become more relevant. Gone is the regimented approach by which you would secure an income for life. Instead pensions can now act much like bank accounts, (albeit ones that carry high income tax ramifications if not managed properly.)
So, if you are going to utilise flexi-access drawdown, (the technical term for freely accessing your pension as required), how much money should you be taking out at any one time, and what are the potential pitfalls?
To address these questions, most financial advisers will use Cash Flow Modelling. At Lonsdale Services we use cash flow modelling to create a Lifetime Financial Plan for our clients.
Cash Flow Modelling
Cash Flow Modelling is the process of predicting the future course of an individual’s cash flow, based on a set of initial and ongoing assumptions. It doesn’t have to be complicated and most people will have done it themselves without thinking to give it a name.
In the past withdrawing money from a cash machine abroad was a costly affair, if your bank card even worked abroad! People would estimate how much money they needed for their holiday, based on spending assumptions, to cover food, excursions, gifts etc. They would then take an appropriate amount of foreign currency with them based on these calculations.
Modelling cash flow for your retirement is a very similar thing, but with slightly different inputs. You need to estimate:
- How much money you need to withdraw every year to meet your needs.
- How much you expect your investments to grow.
- How much money you need to leave for later life.
- How long you expect the plan will have to run.
When you combine these assumptions with the knowledge of how much money you are starting with you can get an idea of how sustainable your plan is.
However not all plans are the same, and the same set of inputs can have dramatically different results as we will see below.
Case 1 – Uniform Return
Let us begin with the simplest scenario, with as few unknowns as possible. The assumptions that we use are:
- The growth rate is constant throughout the life of the plan and is 5.00% every year.
- An income of £5,000 per year will be taken
- The fund value starts at £100,000
- The plan is to run for 20 years
- There is no inflation
| Return | Fund | Withdrawal |
|---|---|---|
| £100,000.00 | ||
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| 5.00% | £100,000.00 | £5,000 |
| Total Withdrawals | £5,000 |
Average Return – 5.00%
Standard Deviation – 0.00%
*Standard deviation is a measure of how much the individual yearly returns differ from the total average return. The lower the standard deviation the more uniform (and predictable) the return.
The cash flow model in this scenario demonstrates that the fund can continue to support annual withdrawals of £5,000 for the life of plan. In fact, because the level of withdrawal is exactly equal to the growth, the plan could support this level of income indefinitely.
There are limitations to this simple model though. For one, we would not expect to receive a constant and level return of 5.00% every year on any investment. Therefore there will come a time when the investment underperforms your expected growth rate, what impact could this have on the sustainability of the planned withdrawals?
Case 2 – Non-uniform Returns
This scenario is an evolution of the first, we look to produce results that might be more similar to the real world. This is achieved by replacing the uniform growth rate with a variable growth rate. As in Case 1 the total growth achieved at the end of the 20 year period will still be equivalent to 5.00% per annum. We will also know the 20 individual annual returns that combine to produce this total return, however we won’t know the order that these returns come in.
Let us look at three different sequences of returns to demonstrate the dramatic impact this can have on the end result, even if the net average return is the same.
|
A- Favourable sequence of returns |
B - Unfavourable Sequence of returns |
C - Random Sequence of Returns |
|||||||
|
Year |
Return |
Fund |
Withdrawal |
Return |
Fund |
Withdrawal |
Return |
Fund |
Withdrawal |
|
0 |
|
£100,000.00 |
|
|
£100,000.00 |
|
|
£100,000.00 |
|
|
1 |
15.00% |
£110,000.00 |
£5,000 |
-5.00% |
£90,000.00 |
£5,000 |
-2.00% |
£93,000.00 |
£5,000 |
|
2 |
11.24% |
£117,365.10 |
£5,000 |
-4.00% |
£81,400.00 |
£5,000 |
5.00% |
£92,650.00 |
£5,000 |
|
3 |
11.00% |
£125,275.26 |
£5,000 |
-3.00% |
£73,958.00 |
£5,000 |
-1.00% |
£86,723.50 |
£5,000 |
|
4 |
10.00% |
£132,802.79 |
£5,000 |
-2.00% |
£67,478.84 |
£5,000 |
7.12% |
£87,895.35 |
£5,000 |
|
5 |
9.00% |
£139,755.04 |
£5,000 |
-1.00% |
£61,804.05 |
£5,000 |
-3.00% |
£80,258.49 |
£5,000 |
|
6 |
8.00% |
£145,935.44 |
£5,000 |
4.00% |
£59,276.21 |
£5,000 |
-5.00% |
£71,245.57 |
£5,000 |
|
7 |
8.00% |
£152,610.28 |
£5,000 |
4.50% |
£56,943.64 |
£5,000 |
9.00% |
£72,657.67 |
£5,000 |
|
8 |
7.12% |
£158,471.09 |
£5,000 |
5.00% |
£54,790.83 |
£5,000 |
10.00% |
£74,923.43 |
£5,000 |
|
9 |
7.00% |
£164,564.07 |
£5,000 |
5.00% |
£52,530.37 |
£5,000 |
5.94% |
£74,373.14 |
£5,000 |
|
10 |
7.00% |
£171,083.55 |
£5,000 |
5.94% |
£50,650.15 |
£5,000 |
8.00% |
£75,322.99 |
£5,000 |
|
11 |
5.94% |
£176,244.21 |
£5,000 |
7.00% |
£49,195.66 |
£5,000 |
11.00% |
£78,608.52 |
£5,000 |
|
12 |
5.00% |
£180,056.42 |
£5,000 |
7.00% |
£47,639.35 |
£5,000 |
5.00% |
£77,538.94 |
£5,000 |
|
13 |
5.00% |
£184,059.24 |
£5,000 |
7.12% |
£46,029.70 |
£5,000 |
15.00% |
£84,169.78 |
£5,000 |
|
14 |
4.50% |
£187,341.90 |
£5,000 |
8.00% |
£44,712.08 |
£5,000 |
4.00% |
£82,536.57 |
£5,000 |
|
15 |
4.00% |
£189,835.58 |
£5,000 |
8.00% |
£43,289.04 |
£5,000 |
7.00% |
£83,314.13 |
£5,000 |
|
16 |
-1.00% |
£182,937.22 |
£5,000 |
9.00% |
£42,185.06 |
£5,000 |
11.24% |
£87,679.48 |
£5,000 |
|
17 |
-2.00% |
£174,278.48 |
£5,000 |
10.00% |
£41,403.56 |
£5,000 |
8.00% |
£89,693.83 |
£5,000 |
|
18 |
-3.00% |
£164,050.12 |
£5,000 |
11.00% |
£40,957.95 |
£5,000 |
7.00% |
£90,972.40 |
£5,000 |
|
19 |
-4.00% |
£152,488.12 |
£5,000 |
11.24% |
£40,562.04 |
£5,000 |
-4.00% |
£82,333.51 |
£5,000 |
|
20 |
-5.00% |
£139,863.71 |
£5,000 |
15.00% |
£41,646.34 |
£5,000 |
4.50% |
£81,038.52 |
£5,000 |
|
|
Total Withdrawals |
£50,000 |
Total Withdrawals |
£50,000 |
Total Withdrawals |
£50,000 |
|||
|
Average Return |
5.00% |
Average Return |
5.00% |
Average Return |
5.00% |
||||
|
Standard Deviation |
5.52% |
Standard Deviation |
5.52% |
Standard Deviation |
5.52% |
||||
As the graph above shows, even if we know exactly what the different annual returns will be, but not how those returns will be distributed, the end results can be vastly different. If you are unfortunate enough to suffer negative returns in the early years it can dramatically reduce the real return that you will achieve overall. We could take this example further by introducing even more unknowns;
- We could change the total growth rate achieved
- We could increase the amount of annual income drawn in line with potential inflation.
- If we consider 20 years too short a time period, we could increase the timeframe under review.
The list of improvements to the model is almost endless, but by setting up your own Lifetime Financial Plan you can model different scenarios to better inform your decision making.
In addition your situation may change over the 20 years of your Lifetime Financial Plan. Many people are now viewing retirement in a different way depending on their circumstances. They may plan to reduce their working hours and may not have a set retirement date in mind. No longer do people think they will save until they are 65 and then stop work and draw on their pension. This creates a degree of uncertainty as to how their financial planning will evolve.
So what is the solution you ask? Unfortunately no one can predict the future, but that doesn’t mean we shouldn’t try. Setting up a Lifetime Financial Plan is an excellent starting point, but it needs to be reviewed regularly, at least once a year, to make sure that you are still on course to meet your financial goals & objectives and to check that your goals haven’t changed. And that brings us to my golden rule:
Regularly review your financial planning situation.
- Check that your investments have performed as required, reassess what you are hoping to achieve and make sure that your plan continues to reflect this.
We recommend using an independent financial adviser who offers cash flow modelling as they can assist you and discuss how to;
- Manage your income in retirement,
- Minimise the risks associated with investing
- Explain what course of action you can take to try to ensure that you continue to achieve your retirement goals.
- Regularly review your investments to make sure that they remain on track.
Lonsdale Service’s Independent Financial Advisers work with clients to achieve their financial objectives. Our Financial Advisers advocate the use of Lifetime Financial Planning and regular financial reviews, at least annually. Once a client’s objective is known we meet them regularly and make changes to their Lifetime Financial Plan. By adjusting a client’s Lifetime Financial Plan to take account of market volatility and variable investment returns we ensure our clients have the best opportunity to achieve their financial objectives.
Daniel Stansall is an Independent Financial Adviser in our Lonsdale Services Barnet office, learn more about our Barnet team. Daniel has passed the Chartered Institute of Insurance (RO8) Pensions Update examination, in order to better qualify him to offer you up to date pension advice. Read Daniel's other pension articles - Do you understand your new pension choices and What to consider when you are a long way off retirement
Please note: The value of investments can fall as well as rise. You may not get back what you invest.
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