Investing always involves taking some risks. However, there are a further set of risks relevant to those in retirement and needing to take income from their investments. These are important to consider when planning finances later in life.
We suggest making a full assessment of these risks ahead of retirement, or obtaining advice or guidance that encompasses this. It is particularly vital when considering pension drawdown – the process of continuing to invest your pension pot and taking out money as and when needed.
1. Longevity risk
This is the risk involved with outliving your resources. How long you live is unpredictable, and people can underestimate how long they will live. This is why guaranteed forms of income such as defined benefit (e.g. final salary) pension schemes and annuities can be valuable in providing a core amount of income that can be depended on.
2. Investment risk
Investment risk is magnified for those taking income from their investments. Not only do income streams such as dividends from shares vary but values can fluctuate according to what markets are doing. If you are drawing a flexible income from your pension care must be taken to ensure enough is left for future needs. The sequence of returns and when (as well as how much) income is drawn can have a considerable impact on results. For more see my article on the risks of pension drawdown here.
3. ‘Mortality drag’
Funds in drawdown must produce increasingly higher returns to match the income you could receive if you bought an annuity. That’s because annuity rates increase as people age. In addition, someone deferring buying an annuity is missing out on ‘mortality cross subsidy’ which means annuity policyholders benefit from the pooling of longevity risk when people die younger than expected.
4. Inflation risk
Inflation is a measure of the rate of increase in prices for goods and services. In the UK the main measures are the Retail Price Index (RPI) and the Consumer Price Index (CPI). If the return on your money is less than the rate of inflation, it will erode the purchasing power of your capital, but it’s also something to bear in mind for retirement income. If a drawdown pension is rising by less than inflation it is losing spending power.
5. Changing circumstances and legislation
Retirement can last several decades. A change in circumstances may require different levels of expenditure and the need to build flexibility into income-generating portfolios. In addition pension and taxation rules are constantly changing and the pace of change shows no sign of abating.
If in doubt seek advice or guidance
What you do with your pensions is an important decision. We recommend you understand your options and ensure your chosen route is suitable for your circumstances. Take appropriate advice or guidance if you are at all unsure. The government's Pension Wise service provides free impartial guidance on your retirement options, or get in touch with a Charles Stanley Financial Planning consultant.
This article is solely for information purposes and does not constitute advice or a personal recommendation. Past performance is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. The taxation of pensions and the rules surrounding them could change in the future. If you are unsure as to whether an investment or a pension is suitable for you, please seek professional financial advice.