One of the issues to consider when preparing a retirement plan is managing risk. In this post, we discuss the key risks that can impact on the value of a retirement fund and the best way to manage those risks.
The Key Elements Of Risk
When anything is uncertain or unpredictable there is an element of risk involved. The more unknown factors involved, the higher the uncertainty and the higher the risk.
Understanding risk vs return is an important part of the retirement planning process. There are four key elements of risk:
Each of which we cover below.
Inflation is the rate of increase (over a set time period) of a basket of goods and services. If inflation increases above the average increase in the value of investments the purchasing power of those investments (cash or assets) falls in real terms.
Holding cash or investing in an asset that is not linked in some way to the rate of inflation gives rise to inflation risk. Living for 20 – 25 years after retirement is a reasonable expectation. If inflation were to remain at a consistent 3% level £1,000 today would have the purchasing power of roughly £500 in 2045
Investing is a long-term exercise and it is easy to get sucked into a short-term view. In recent years it has been assumed that annual investment growth of 4% would cover the impact of inflation and deliver fund growth.
With UK inflation ranging between (broadly) 0.5 and 2.5% between 2015 and 2018, this assumption has been valid over the short term. However, as recently as 2011 inflation was over 4.5%.
The price of over 100,000 goods and services are measured each month to calculate the RPI and CPI. They are weighted and a computer algorithm calculates the monthly inflation (percentage) rate. What really matters to those in retirement is not what the rate of RPI or CPI is but the impact that inflation has on the key items, where the majority of their money is spent.
For example, in retirement, a mortgage may be paid off but the bills still need to be paid. What happens if the price of utilities (electricity, gas, water) consistently increases more than inflation? With no travel to and from work in retirement the price of petrol may be less relevant but what if food prices increase significantly compared to the other items used to calculate inflation?
In any pre-retirement planning exercise, one of the key issues to consider is investment risk. It defines the possibility a loss will be made on an investment. The classic small print states “The value of investments can go down as well as up.” In general, more risky investments have more chance of a significant downturn. One of the key strategies employed to minimise investment risk is diversification (a risk management strategy that mixes a wide variety of investments within a portfolio).
Investment is a possession acquired with the expectation its value will increase over time. The objective of investing is to beat inflation (see above) and create a real return. But a bad investment decision could mean a return lower than the actual amount invested. Worse still, choose an investment that is not covered by the Financial Services Compensation Scheme (FSCS) and if that investment fails there is very little chance of recovering any of your money.
Over a 30 to 40 year period of saving for retirement history shows, there will be several serious financial market fluctuations impacting on the value of pensions. Assuming ongoing contributions to the pension pot then downturns are not a major problem during a working lifetime. Investments tend to recover (and more) the losses accrued during the downturns.
During retirement it is probable contributions to the investment fund will stop and regular withdrawals will be made instead. With no contributions and perhaps limited time to recover downturns can do more harm to those in retirement. The situation is compounded if significant withdrawals are made during market downturns.
In simple terms, longevity risk is the risk of running out of cash and/or assets in retirement leaving you at the mercy of whatever state provision may exist at the time. It raises a number of questions, many of which do not have a definitive answer.
No one can know how long they may live and there is always the temptation to spend today as it may not be possible to spend tomorrow. But the evidence shows we are all living longer. It is estimated between 2015-2020 the percentage of the UK population over 85 years old will increase by 18% and will increase further thereafter.
Although understandable, the spend today approach can have major long-term consequences and it is important to identify what those consequences may be. What if cash reserves run out in retirement, will any state provision be enough? What about any unexpected expenses? What if long-term care is required?
Liquidity risk arises when it is not possible to sell an asset when you need it/or at its true value. Liquidity can affect those approaching retirement and those in retirement in different ways.
Care needs to be taken on the nature of investments held in a portfolio and the relative proportion of each of those investments. Certain investments, by their very nature, are not liquid assets i.e. property. This can be a real problem depending on when those assets need to be sold, especially if they need to be realised quickly to cope with an emergency.
Pre-retirement planning is essential but it can be complex and time-consuming. The consideration of risk and how that risk may be minimised while retaining an appropriate rate of pension fund growth is a key issue. It is important to remember, forecasting risk is not an exact science. There is always the risk of major economic changes, that nobody can predict, having a medium to long-term impact on pension funds. It is always sensible to consider the provision of a safety net.
This blog is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investment or course of action. The past is not a guide to future performance. The value of investments can go down as well as up and you may not get back the full amount you invested. Tax and financial regulations can change. Any figures quoted above are correct at the date of publication.