The four risks of investing in retirement and how to prepare for them

One of the most significant events in an ‘investment’ life is the move into retirement as, for many people, this leads to a switch in the direction of the flow of money.

Up until retirement investors may top up their portfolios from their earnings, taking advantage of opportunities and counter any weakness in financial markets. This period of accumulating wealth is turned on its head in retirement as the opposite happens and investors look to access their capital and withdraw money from their savings and investments. This is often referred to as decumulation or drawdown. 

Taking money out of a portfolio rather than being able to add to it has a significant impact on the behaviours of investors and the risks they are exposed to. Typically, investor focus shifts from growth to a greater certainty on returns. Timescales adjust to becoming shorter term as there is a more immediate need for the income and savings. 

We have identified four specific risks that investors should consider when investing for and during retirement. These are longevity, inflation, market and sequencing risk. Here we define them and explore how they can impact investments. We also offer possible solutions that can help mitigate the impact of these risks.

Upon retirement, investors will have a fair idea of how much they will have, and this is unlikely to change significantly. What they are less likely to know is how long they will need that money to last. While many people probably prefer not knowing when they will die it does present a challenge when it comes to investing. 

According to the Office for National Statistics, the average life expectancy in the UK is 79 years for men and rises to 83 years for women.  Of course, these are averages so some people might live much longer than that and indeed longer than they expect. The risk is that they run out of savings and investments in their later years.

Inflation is insidious, it constantly erodes the value of investors’ hard-earned wealth and over the long-term, even low inflation, has a significant impact on the real value of any investments or savings. Inflation does not need to be at headline grabbing highs to really impact wealth.

For example, since 2015 inflation, as measured by the consumer prices index (CPI), has cut the value of savings by a third.¹ Inflation will erode current and future purchasing power and could affect the lifestyles have in retirement. 

Volatility is unavoidable, but the relationship investors have with it changes in retirement. In retirement the focus typically switches from targeting growth to achieving capital preservation. 

Investors are less tolerant and more sensitive to market volatility in retirement because they are less able to add more money to their portfolio in the event of any falls and could suffer a permanent loss which impacts their retirement plans.  

Closely linked to market volatility, sequencing risk looks at the timing of when markets rise and fall. Even small drops in a portfolio at the start of retirement can have a significant long-term impact on investments. This is because money is being taken out of investments and the size of the withdrawal as a proportion of the whole is larger when the value drops.

The chart below illustrates how sequencing risk impacts two example portfolios, which have £500,000 invested in them. Performance of the two portfolios over 30 years is identical. Both have £20,000 taken out each year but Portfolio A experiences a rising market in the first three years (4%,3%,5%) whereas Portfolio B falls (5%,3%,4%). Portfolio B runs out of money, whilst portfolio A has over £200,000 left.

There is no one size fits all solution for investing in retirement as everyone’s experience will be unique so investing for retirement will need to be tailored to the individual circumstances.

A common approach to investing in retirement is to switch all investments into lower risk, income generating assets, such as bonds. This approach will be the right solution for some investors, particularly those who can comfortably live off the income. However, it doesn’t protect them from the four risks mentioned and may lack the flexibility others need. 

To mitigate the risks, it’s important to remove the immediate need to access the portfolio, changing how the annual income is taken from the portfolio.  To achieve this, savings and investments can be split into the below three buckets. 

First bucket – The cash buffer 
Typically, advisers recommend having one to two years’ worth of income in cash. This should be enough to cover daily expenditure and offers some protection against the market risks but doesn’t remove it entirely. 

Second bucket - Drawdown portfolio 
This would take a portion of wealth and use it to build a specific portfolio designed to meet any income requirements for the next four or five years. The investments here are typically going to be lower risk and may include short-dated government bonds, structured products, which tend to offer a higher total return, or both. 

A drawdown portfolio can be tailored to personal income needs. This approach means there is a clear cash flow for the short and medium term, up to seven years so there is no need to draw on the remainder of the investments.

Third bucket - Growth portfolio 
The remaining bulk of the portfolio is invested in growth assets. There isn’t an income requirement for the portfolio so the focus can be on delivering long term growth. This would help to address the longevity and inflation risks as growing the portfolio, ideally above the rate of inflation, should increase the size of the overall pot. However, there would still be an investment risk and the assets could fall in value. 

Our flagship Discretionary Portfolio Service is designed for clients where a tailored portfolio is most appropriate to meet an individual’s specific goals. At the heart of our process, we seek to preserve and grow the real value of client assets through time. Investments can also be managed in line with a client’s unique income requirements. This service enables you to maintain close client contact while delegating the responsibility for managing your clients’ investments to Evelyn Partners. 

1. LSEG Datastream/Evelyn Partners