Life After Full-time Work Blog

Answering readers’ questions on the previous (FT Money) post

“Your pension, your risk, your choice” was an article I wrote for FT Money’s edition of April 10, 2021, and I used it as my blog post last time. From the 100+ comments on the FT website, it was helpful to many readers. But they also had follow-up questions. Here I’ll respond to four of them: spending patterns in retirement, annuities for longevity risk, flexible withdrawals and tax.

And I’ll clarify a misunderstanding about the changing level of exposure to equities.

First, as background, let me summarise the approach I described that I use for my wife and myself.

We selected a planning horizon of 31 years, which according to a much-used longevity table reduced to 25% the chance that one of us might survive longer. In other words, that’s a 75% chance of success in not outliving our pension pot, our acceptable risk level. We calculated the sustainable annual withdrawals that went with a combination of five years of after-inflation (and before-tax) withdrawals invested in short-term securities (our insurance bucket) and the rest in a global equity index fund (our growth pot). Why five years? Because historical statistics suggested that it gave us that same 75% chance of success, in this case that the market would recover after any fall and we wouldn’t have to cash out from a depleted growth pot. There was lots more about risk, and adjustment to changing circumstances – but that’s the essence of it.

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Many readers wondered about typical spending patterns in retirement, and also about inflation. Let me link the two subjects.

Research suggests that the typical pattern of activity in retirement seems to follow three stages, colloquially called go-go, slow-go and no-go.

At first (go-go) we explore the physical, mental and social goals we’ve had repressed inside us for some time, and we’re happy to be able to release all that pent-up energy and longing. But it’s not forever. Things become less exciting once they’re repeated, and we also tend to lose vitality gradually. Hence the slow-go stage, when our lives downsize and our activities are more localised, and sometimes we also choose to downsize our homes. Commentators say this may start around age 70 or 75, but obviously that varies enormously from couple to couple.

The no-go stage is much less common. That’s the unfortunate stage in which we may need long-term care. The best statistics I’ve seen (from US insurance companies) are that perhaps one-third of their long-term-care policyholders make claims for care that exceeds 90 days. The cost of long-term care varies not only from one country to another but possibly from one location in a country to another. If it concerns you, I suggest you seek expert help.

This pattern has financial implications. If our activity isn’t constant, then neither is our spending. As our activity gradually declines, so does our spending. Much later, for some of us, it may turn up again, if we need and have to pay for long-term care. The image that I tend to remember is one that was invented by Dr David Blanchett: it’s that, if you draw a curve showing how retirement spending changes as we age, it may look like a smile. Whatever level it starts at, it tends to go down gradually, and might turn up again near the end.

In general, therefore, even if we can’t find a way to keep up with inflation precisely, it isn’t strictly necessary to keep up fully when our spending pattern itself declines. Given his investigations into the rate at which go-go becomes slow-go (and perhaps, for some, no-go) over time, Dr Blanchett suggests that we’re likely to be close to OK if we budget for spending growth that’s 1% a year below inflation.

Implementation steps could involve some purchase of a guaranteed lifetime income (whether or not linked to inflation), or simply self-insuring your longevity risk, in which case you might also consider the purchase of index-linked bonds.

Two more quick thoughts. One is that some of your income may already be fully linked to inflation (like a government age pension, in many countries), so the drawdown from your pension pot typically suffices if it increases somewhat less than 1% below inflation. The other thought is that studies show that retiree inflation is actually quite close to general population inflation, within 0.25% a year typically – not enough to worry about the differential.

That’s the best research I can find, and I know that everyone is an individual, and potentially different from the average person.

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Which leads naturally to hedging your longevity risk. Obviously this only matters if you are in at least average health, so I’ll take that as a given.

At the extremes of wealth, longevity isn’t a relevant risk.

There are unfortunately some retirees who don’t have enough to satisfy their needs, let alone their wants, so longevity is no more a problem than everyday life. At the other extreme, there are some who can satisfy both needs and wants for longer than the end of the longevity table, so longevity isn’t a risk that upsets their lifestyle. (I’m ignoring the bequest motive, which may seem unreasonable, but there are ways of coping with it separately that I haven’t the space to go into here.)

It’s in the (vast) middle that longevity is a risk that could mean doing without some or much of one’s wants if one’s lifespan is too long. Let’s consider them.

Here’s a thought experiment I conducted before I retired, subsequently greatly improved by my colleague, actuary Bob Collie. On (hypothetical) Planet 1, everyone lives to exactly their life expectancy, but investment returns are uncertain. Obviously that causes uncertainty about how much it takes to lock in your lifestyle (needs and wants, together) for the rest of your life. On (hypothetical) Planet 2, investment returns are certain, but longevity is uncertain. That too causes uncertainty about the lock-in amount. Question: which planet causes greater uncertainty?

Answer: it depends on your age. At male age 60 (or female age 65), longevity uncertainty has less financial impact than investing 100% in bonds. Easy to live with. The two impacts get closer and cross over as age increases. By male age 75 (female age 80), longevity uncertainty has a bigger financial impact than investing 100% in equities. Most of us at that age would find that amount of equity risk intolerable and frightening. That implies that, by that age, we should definitely hedge our longevity risk.

How? Dr Geoff Warren has explored this question in multiple papers. Here’s my summary of his findings. I need to say explicitly: this isn’t specific advice for anyone, just a set of general results over a number of simulations of people’s circumstances and risk tolerance.

If there’s some “must have” minimum income in your mind, in addition to your government age pension (for example, enough to meet your needs), consider locking it in with an immediate annuity, that is, a guaranteed lifetime income starting now. You might then use the rest of your pot a la my approach described at the start.

If there isn’t a “must have” but there is a desirable target income (so, some risk in meeting it is acceptable), then generally for that target income longevity insurance (often called a deferred annuity) commencing at an advanced age such as 85 is the least expensive longevity hedge; next best is an immediate annuity. Whichever you choose, the rest of your pot might follow my approach. A big problem is that this kind of longevity insurance is difficult to find in most countries.

Guaranteed annuity contracts are necessarily underwritten by life insurance companies with very conservative investments, so they’re often considered expensive, particularly in the current era of extremely low interest rates. There’s an alternative being developed (so I’m told) in a number of countries, under which you contribute a lump sum to enter a “longevity pool” which pays out an income guaranteed to last for life, but with the annual income payments varying according to the actual subsequent mortality experience of the participants. A nice feature of a longevity pool is that it can be invested in growth-seeking assets, not just safety-oriented ones, so the hope is for a higher long-term average income – an expectation rather than a guarantee.

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A number of readers said that they use flexible withdrawals in response to changes in the market value of their growth pot. An excellent idea! I do too. All I meant to say, in the original article, was that I don’t vary the withdrawal in proportion to the market swing. Instead, I spread the amount of the swing over our remaining planning horizon, to smooth it out. The swing in your pension pot’s value caused by a large proportion being in equities could result in a very large swing in the amount withdrawn. If you can stomach it, that’s terrific. It’s those who’d prefer smaller, more gradual swings that the spreading process appeals to.

Spreading relies on a belief in (or at any rate a hope for) “mean reversion,” the notion that, over the long term, returns will come back to the average. But if future market declines are steeper and longer than before, the gradual declines in withdrawals won’t be enough. It’s a risk to be conscious of.

Actuaries Fred Vettese and Malcolm Hamilton studied retiree spending patterns in Canada, and found that retirees adjust their lifestyle to their income, and indeed they continue to save, even on incomes much lower than when they were working. Those retirees probably didn’t have nearly as much equity exposure as my approach suggests; but that research does raise the possibility that accommodating valuation swings isn’t as much of a practical fear for retirees as is generally believed.

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Finally, tax. Each year’s withdrawal is subject to tax, so you don’t get to spend it all. For many, tax will itself be a significant expenditure. So if there’s a way to minimize it, that becomes important.

I have no general principles for you. That’s because tax regimes vary from country to country. It’s as if you’re asked to approach the taxing authorities with all your money stuffed in various pockets in the clothes you’re wearing, and they say, “From Pocket A we’ll take 40%, from Pocket B 20%, you can keep whatever is in Pocket C, from Pocket D …” And so on.

Naturally, before you approach them the following year, it makes sense to rearrange your money across the pockets. But finding out how to do this is difficult, and whole tribes of people make their living by getting to know the complexities and advising non-technical citizens like you and me about how to minimize the total.

Also, while in some countries moving money from A to B is sensible, in other countries the opposite is true; and yet other countries use a different alphabet entirely, which sounds like Greek to you.

That’s why tax is hugely important, and why I have no general principles for you.

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Now a misunderstanding – I’m sorry I wasn’t clear enough.

One reader suggested that my approach flies in the face of traditional financial planning advice, to progressively reduce your equity holdings as you age. Actually, so does my approach. Ideally I have five years of withdrawals in my insurance bucket and the balance in equities. As the planning horizon draws nearer, the bucket doesn’t decline but the balance does, so the equity proportion falls. In fact, five years before the end of the planning horizon I’ll have nothing invested in equities.

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