The option when you retire to keep your pension intact, known as pension flexibility, may lead to the thought that not much needs to change in your approach, before and after retirement.

This is because you may think that all that you need to do is switch on income.

 

Let us provide a simple example.

You have £300,000 in pensions on the day you retire. These would be pensions which are invested, for example personal pensions. You have built these up to support your income needs when you retire.

You retire and you decide you want £15,000 per year from these pensions.

That’s 5% per year (to start with).

So, logically you keep the pensions as they are but instruct your pension company or companies to ‘turn’ on an income to be paid from these funds.

This is over-simplified to a point, because you would have to consider other aspects, such as the tax-freedom that you would get from some withdrawals and not others and so on, but this does not affect the thrust of this article.

Essentially the change is in pre-retirement you do not take/receive income from your pensions, post-retirement you do.

When you switch from no income to income, you are in effect making a switch from accumulating to decumulating.

Your goal has changed from building up your funds, to drawing down your funds.

The moment you make this switch, you change the nature of the risks you face and the way you should approach this.

This does not always mean you need to do anything different, but it often does, and – for sure – you should be aware of the new and different risks and you should explore whether you do need to take a different approach.

 

Why is this?

It’s to do with several connected things, and we can touch on two.

The first is that you are now faced with a sequence of returns risk.

This risk simply does not exist pre-retirement.

Sequence of returns risk is triggered because your withdrawals quantify and convert paper losses on investment value, into real and actual losses, should investment falls occur.

It is very easy to illustrate this effect with an exaggerated example.

You have £300,000 in pensions and you decide to withdraw 20% per year from this. We know this is a silly amount, but we use it to make the case as clear as we can.

Now imagine that you are not taking income, and you have £300,000 invested, and over the following three years you experience investment returns of – 50% year one, + 100% year two and 0% year three. Again not a normal experience, but still illustrative.

Your portfolio value at the end of three years will be £300,000, the same as when  you started.

 

What do you think the value will be for you if you were withdrawing 20% per year?

£60,000

You have withdrawn £180,000, so add that to the £60,000 you have left in the pot and your total return is £240,000. You can see therefore the damage done by having the early year loss and the withdrawals.

This extreme example is provided to highlight how the effect works, if you have volatile investment returns and are making withdrawals, then the sequence of those returns, allied to the level of withdrawals can be destructive. Especially when losses occur in the early years after you start withdrawals.

Retirement and withdrawing income from pensions is commonly a multi-decade exercise so these effects do not have to be wild to create a problem.

The second connected thing is that you now must calculate how to decumulate most efficiently, and this is complex, way more than most realise.

Let’s assume you retire at age 60 and die at age 91, it will only be at 91 that you (or your adviser!)  can conclude the most efficient way you should have decumulated.

That’s because you could then run simulations of all the possible ways you might have done it, knowing (then) what the investment market return has been, how long you needed to provide an income for and can compare all the possible withdrawal strategies, the amounts, the regularity, the tax position etc.

But you need to do this in advance, because the efficiency scale of different outcomes is surprisingly large. Put another way, the most efficient method will leave you with a lot more in the pot and/or provide a much higher income than the least efficient strategy.

 

The prize for efficiency is high.

How do you do this in advance when you don’t know the answers to the key questions, of future investment returns, how long you will live etc.?. Naturally, there’s no fool proof way, but you can do some testing by comparing simulated positions, future assumptions etc. And this will inevitably include a different approach to the pre-retirement set up in many cases. In other words, if you retire and you keep doing what you were doing while you accumulated, you could easily find this is obviously non-efficient.

Decumulation, which is what you switch to as soon as you start drawing income, changes the dynamic and it is a very good idea to recognise this before it happens and to explore how this may impact your position.