Transitioning into Retirement
Given that retirement is something that ‘most people’ look forward to…you’ve worked and saved hard…you’ve got a bucket list of things you still want to do and achieve…why does it sometimes not quite ‘feel right’?
You know you’ve got enough money (i.e. you are now financial independent) but ceasing paid work, and moving from the stability of a regular pay cheque to living off your accumulated savings is sometimes a hard adjustment to make. Experience with our own clients tells us that it can take a couple of years to settle into a spending pattern and to make that mental shift from accumulation to decumulation.
Here are six tips to help you to avoid the common mistakes people make and to enjoy your hard earned financial independence.
1. Don’t underestimate how long you might live
Unless you have a serious health issue, the evidence suggests that an affluent couple who have reached age 65 can reasonably expect to live for another three decades. Longevity, as life expectancy is known, is continuing to improve although more slowly than in the past and there is no reason to suggest this trend will not continue. Planning for a short retirement is not a sensible strategy.
2. Don’t underestimate the effects of inflation on your income and capital
Almost everything that you want to buy will get more expensive each year and fewer of us are retiring with a fully inflation-linked guaranteed pension. That means that to enable you to be able to continue to afford your lifestyle costs and avoid running out of money before you run out of life, your wealth is likely to need to generate a return over inflation. Even if you are lucky enough to have an inflation-linked pension, there is no guarantee that its rate of increase will match that of your own expenditure. Even modest levels of inflation can have a very serious impact on spending power and the longer the time period the worse this can be. A relatively modest inflation rate of 3.5%pa (which is roughly the annualised average of the UK Retail Prices Index since the beginning of the 1990s) will halve the value of your money after around 20 years.
3. Beware of products offering ‘low risk’ returns which are significantly higher than cash deposits
You might also be seduced into buying structured products which purport to offer a market-beating return as long as one or more market indices do not fall (at all or by more than a certain percentage) over a set period. These products are rarely created to benefit the end investor, i.e. YOU.
Beware of products offering ‘low risk’ returns which are significantly higher than cash deposits. If something looks too good to be true, it probably is. If there were really low risk high return investments, everyone would buy them, their price would rise and their returns would fall to a level consistent with investors’ expectations of their actual risk.
A total return approach, within a well diversified portfolio, where you use a combination of interest, dividends and capital to fund your living expenses, is likely to be the most effective (and tax-efficient) approach, although it does require structure and discipline.
4. Don’t confuse volatility with permanent loss of capital
A well-diversified investment portfolio, with a sensible allocation to real assets such as equities, has a good chance of providing both inflation protection and additional (i.e. real) returns over the long term (25 years or more). The price you pay for this higher expected return is volatility, i.e. your investments moving up and down each day based on the balance of supply and demand according to investors’ collective perceptions of the current and future earnings generated by the underlying businesses.
The chances of experiencing a permanent loss of capital with a fully diversified investment portfolio are extremely low. The chances of a permanent loss of capital from investing in things like private equity, hedge funds and single company equities is much, much higher.
5. Don’t think that you need access to all of your capital all of the time
Holding excessive amounts of cash on deposit when you are unlikely ever to need such funds comes at a high price. Cash has historically been a poor hedge against inflation and holding too much in cash means that your other investments have to work even harder to generate the necessary returns to protect your capital against such inflation. As a general guide, you should hold on deposit about twice that element of your annual living costs that can’t be met from guaranteed pensions, rental or other predictable income, plus sufficient to cover any known capital expenditure which is likely within the next three years or so. You may wish to hold more or less cash than this but it is a good starting point.
6. Don’t spend too little or too much
Making the adjustment from a regular pay cheque to living off your wealth can be difficult and you should allow yourself time to make that adjustment. Spend too much and your wealth could be exhausted too rapidly and your standard of living seriously affected. Spend too little and you run the risk that you don’t enjoy life as much as you might while you remain fit and well and, in addition, all you do is increase the inheritance tax that will ultimately become due on your estate.
A proper lifetime cashflow analysis (your ‘Bucket’) will enable you to stress test a range of scenarios based on a range of factors such as spending level, inflation rate, investment allocation, investment returns, tax rates and time horizons. Once you understand the range of possibilities, you can start to determine an appropriate strategy.
If you can avoid these common mistakes you will minimise the chances of financial failure. That means that you can live your life to the full and free from fear, worry and anxiety about money; that’s got to be something worth living for!
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