Pensioners and would be retirees are exposed to a number of different risks. Typically, when we talk about risk, we think about the risk of investments rising or falling in value. However, when considering your retirement income structure, you need to consider a number of different risks that apply; these are:
- The risk of inflation
- The risk of Annuity rate movements
- Longevity risk
- Investment risk
- The risk that your personal circumstances may change
The risk of inflation
Over the past couple of years inflation has never been far from the headlines and it remains a serious risk for pensioners.
The impact of inflation is to devalue an investment, savings or income in ‘real terms’, which means a reduction in your spending power. You will be able to buy less in the future than you can today if the rate of return on your investment or savings does not match inflation. The same is true of your income.
The Bank of England is responsible for trying to control inflation and has a long term target of maintaining the Consumer Prices Index (CPI), which is one measure of inflation, at 2%. If inflation remained at a constant 2% per annum, then the real value of a £10,000 income today would be £7,386 in 15 years; more than a 25% reduction in real terms.
Many people are attracted to the higher income from a level Annuity and although in the short term this might meet their requirements, in the longer term they will see the spending power of their income reduce significantly because of the effects of inflation.
The risk of Annuity rate movements
The timing of an Annuity purchase can have a big impact on the level of income available. Annuity rates are to a great degree linked to gilt yields. Rates fluctuate and can have a significant impact on the level of income available between one month and the next.
Predicting Annuity rate trends, and therefore the timing of your purchase, is becoming increasingly complex.
Not only is it important to monitor changes in gilt yields but also to take into account changes in life expectancy.
Several retirement income options allow you to defer the purchase of a Lifetime Annuity to a future date. Whilst these options provide much needed flexibility, there is a risk that when you eventually purchase an Annuity, rates may be lower than at present; of course, they may be higher.
Longevity risk is effectively the risk of living too long!
Life expectancy has significantly increased over recent decades. According to the Office for National Statistics (ONS), the average life expectancy in the UK for a male currently aged 65 is a further 18 years, and 20 years for a female.
Some options described in this report remove longevity risk by promising to pay an income for the remainder of your life, and, where selected, that of your partner.
Other products leave you exposed to longevity risk, and the potential of a depleted pension fund with several years of income still required.
In the worst cases, this will mean that income levels are reduced significantly in retirement. This risk is closely related to Investment Risk (see below), and can be managed through appropriate investment strategies.
Your own health is closely related to longevity risk. There can be some advantages gained by deferring a Lifetime Annuity until later in life, as life expectancy becomes more predictable. In addition, if your health worsens, it may be possible to take advantage of Enhanced Annuity rates rather than normal Lifetime Annuity rates.
Several of the options described later provide you with the opportunity to continue investing your funds for potential future growth. This will therefore continue to expose your fund to your chosen level of investment risk.
It is possible to invest these funds in a manner that is designed to limit the downside of any economic turbulence. However, you will need to consider the level of return required to make such a plan a success. Typically, if you target higher returns, you may need to increase the level of risk you are taking. This can mean that there is potential for a higher upside, which is matched by the potential for a greater loss on the downside.
Some contracts, such as Fixed Term Annuities offer a facility to limit the downside of investment risk. This works by providing an underpin of either a minimum income, and/or a minimum fund value.
The risk that your personal circumstances may change
Your circumstances have no doubt changed throughout your life, and it is likely that they will continue to evolve. It is important to consider how you see your retirement developing and the potential life changes that may occur.
Some options, such as a Lifetime Annuity, offer no future flexibility or possibility of change; others offer the opportunity to change at certain points in time; and others offer full flexibility.
Each option comes with its own set of risks, and compromises may need to be made in order to find the most suitable structure for you.
Our team of Independent Financial Advisers in are experienced in developing retirement income strategies for clients the length and breadth of the UK. If you are approaching retirement and would like advice on your options call one of our IFAs today on 0115 933 84330115 933 8433, alternatively enquire online or email email@example.com