ROYAL LONDON POLICY PAPER 18 Avoiding Hidden Dangers in ...€¦ · pot so you can sustain a...

ROYAL LONDON POLICY PAPER 18

Avoiding Hidden Dangers in Retirement

ROYAL LONDON POLICY PAPER Avoiding Hidden Dangers in Retirement

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ABOUT ROYAL LONDON POLICY PAPERS

The Royal London Policy Paper series was established in 2016 to provide commentary, analysis and

thought-leadership in areas relevant to Royal London Group and its customers. As the UK’s largest mutual

provider of life, pensions and protection our aim is to serve our members and promote consumer-focused

policy. Through these policy papers we aim to cover a range of topics and hope that they will stimulate

debate and help to improve the process of policy formation and regulation. We would welcome feedback

on the contents of this report which can be sent to Steve Webb, Director of Policy at Royal London at

[email protected]

Royal London Policy Papers published to date are:

1. The “Living Together Penalty”

2. The “Death of Retirement”

3. Pensions Tax Relief: Radical reform or daylight robbery?

4. Britain’s “Forgotten Army”: The Collapse in pension membership among the self-employed – and

what to do about it.

5. Pensions Dashboards around the World

6. The ‘Downsizing Delusion’: why relying exclusively on your home to fund your retirement may end

in tears

7. Renters at Risk

8. Pensions Tax Relief: ‘Time to end the salami slicing’

9. The Mothers Missing out on Millions

10. The Curse of Long Term Cash

11. The ‘Mirage’ of Flexible Retirement

12. Will harassed ‘baby boomers’ rescue Generation Rent?

13. A three-point Royal London manifesto for pensions

14. Could living together in later life seriously damage your wealth?

15. Has Britain really stopped saving?

16. Helping Defined Benefit pension scheme members make good choices (with LCP)

17. Automatic Enrolment and the law – how far do employer duties extend? (with Eversheds

Sutherland)

The Policy Papers are available to download from http://royallondon.com/policy-papers

mailto:[email protected]

http://royallondon.com/policy-papers


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AVOIDING HIDDEN DANGERS IN RETIREMENT

Executive Summary

The pension freedoms introduced in 2015 changed the way we take income in retirement. No longer having

to buy an annuity has increased flexibility enormously but people are now responsible for working out how

best to make their pension last so they don’t run out of money in retirement. That means deciding how

much money to take out each year and it means setting an appropriate investment strategy. It goes without

saying that your income won’t last as long if you take a lot of money out of the pension pot early on. But

what should you invest in?

This paper considers two hidden dangers in deciding the best investment strategy to sustain an income in

retirement. Are you taking enough risk to generate the growth you will need to sustain income

for a long time? Are you taking the right kind of risk to avoid nasty surprises that could force

you to reduce the income you are taking?

Are you taking enough risk?

The average 65 year old can expect to live for more than twenty years, so post-retirement investing is

still long term investing. There may be a temptation to lock in past gains by shifting everything into cash

when you start to draw an income but playing it too safe can mean your investments stop growing and

the pension pot runs dry. If you’d invested a typical £100,000 pension pot in cash ten years

ago and taken income of £7,500 a year from age 65, in line with annuity rates at that time,

there would only be £27,000 left by now and the pot would soon be empty. To make your

pension pot last longer you need your investments to grow and that probably means keeping at least

part of your money in company shares. If you’d invested the same £100,000 pension pot in UK

company shares ten years ago and taken the same income you’d have benefitted from a

rising stock market and would still have £48,000 left today.

Are you taking the right kind of risk?

Large losses early in retirement can have a very negative impact on your ability to sustain

an income for as long as you’d like to. This argues against investing the whole pot in company

shares as they can see significant year to year swings in price. It also argues against taking excessive risk

in the hunt for income. Some of the exotic high yield investments on offer today such as aircraft leasing

or peer to peer lending could expose you to unexpected credit losses when interest rates rise. For most

people, the right approach will be to aim for steady growth but to reduce risk by

spreading investments across a range of different investments including company


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shares, bonds and property, both at home and abroad. An active manager can vary the

proportions held in each type of investment with the aim of incrementally increasing returns while

reducing losses in poor market conditions.

We use forward looking projections to show how a multi asset approach can help you to grow your pension

pot so you can sustain a reasonable level of retirement income. For a pension pot of £100,000 we

find an income of around £4,000-£4,500 a year is likely to be sustainable long into

retirement. This is similar to the level of income on offer from annuities in today’s low interest rate world

but a drawdown pension gives you much greater flexibility and offers a higher likelihood of having

something of value left to pass on to the next generation when you die.

Retirement is a journey. The pension freedoms give you a high degree of control over your own pension pot

but there are hidden dangers in choosing the right investment strategy and in deciding the appropriate level

of income to draw out. A financial adviser should be able to conduct a regular assessment as to

the sustainability of your retirement income and help you make any necessary adjustments

to your investments or to your plans as your financial circumstances change.


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1. How long do you need your pension for?

The pension freedoms introduced in 2015 changed the way we take income in retirement. No longer having

to buy an annuity has increased flexibility enormously but people are now responsible for working out how

best to make their pension last so they don’t run out of money in retirement. That means deciding how

much money to take out each year and it means setting an appropriate investment strategy.

Before the reforms you could take some tax free cash as a lump sum at retirement but the bulk of the money

you’d saved up during your working life had to be used to buy an annuity that would pay you an income for

the rest of your life. However, improvements in life expectancy and the drop in interest rates mean annuity

rates are very low today and with an annuity the next generation is often left with nothing after you die.

Chart 1 shows how life expectancy has improved every ten years since the mid 19th Century when German

chancellor Otto von Bismarck made his country the first nation in the world to offer an old age pension.

The pension age was set at 65 on the basis that most people didn’t make it that far. Pensions were seen as a

form of welfare for those “disabled from work by age and invalidity”.1

Chart 1: Life Expectancy at age 65, England and Wales, 1841 to 2011

Nowadays most people make it to age 65 and most can expect to live for more than twenty years in

retirement. What used to be an insurance policy to cover you in the unlikely event you lived too long to keep

working became an income almost everyone could claim for years. This meant insurance companies

offering annuities had to invest the assets backing them in government and corporate bonds paying

1 Quote from letter from German Emperor William the First to German Parliament: https://www.ssa.gov/history/ottob.html

https://www.ssa.gov/history/ottob.html


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predictable annual payments. That’s where the low interest rates we’ve seen since the financial crisis come

into the story.

The sharp drop in the rate of interest paid by the government to borrow money in the bond market,

combined with the increase in longevity, has cut the amount of annuity income you can buy at retirement

dramatically. Chart 2 shows that the lifetime income you could buy at age 65 with a typical pension pot of

£100,000 has fallen from £7,500 a year in 2008 to less than £5,000 a year today.

Chart 2: Average level annuity for a £100,000 pension pot at age 65

Source: Royal London

It’s not surprising that being forced to buy an annuity became unpopular. Some people felt they were not

getting enough income to live on. Others felt it unfair that there was nothing left over to pass on to the next

generation when they died.

The pension freedoms of 2015 allow you to access the money you have built up in the way best suited to

your individual needs. Some people will want to take the money out over a relatively short period of time.

Perhaps you have a small pension pot you would like to make use of before a larger defined benefit pension

kicks in. Maybe you would like to supplement your income in early retirement to travel or pass money to

family. If you plan to use your pension pot like a bank account, drawing the money down over a short

period of time, and taking possible tax consequences into account, it makes sense to adopt a cautious

investment strategy based around investments like cash and government bonds.

£4,000

£4,500

£5,000

£5,500

£6,000

£6,500

£7,000

£7,500

£8,000

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017


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Most people have the long term in mind and will want to draw a reasonable income from their pension pot

for as long as possible, using the state pension as a fall back. If this is your situation you will need to decide

what you think is a sustainable level of income to take. You will also need to decide an investment strategy

for the pension pot as you start to withdraw income.

This paper considers two hidden dangers in deciding the best investment strategy to sustain in income in

retirement. Are you taking enough risk to generate the growth you will need to sustain income for a long

time? Are you taking the right kind of risk to avoid nasty surprises that could force you to reduce the

income you are taking?

2. Are you taking enough risk?

With pensions drawdown you remain in control of the investment strategy for your pension pot after you

start to draw an income. There may be a temptation to lock in investment gains made during your working

life by shifting everything into cash but playing it too safe will mean your investments stop growing and the

pension pot could run dry ahead of time. Post-retirement investing is still long term investing.

To illustrate the importance of continued growth when you take income we have looked at what would have

happened had you been able to take advantage of pension freedoms ten years ago in 2008. Table 1 shows

that if you’d switched a £100,000 pension pot into cash at that time and taken income of £7,500 a year in

line with annuity rates that were available for someone aged 65, there would only be £27,000 left in the pot

by now. This sum would run out in another four years or so, leaving you reliant on the state pension and

other sources of income, if any, from that point onwards.

Table 1: Simulated pension drawdown investing in Cash, 2008-2017

Pension pot at

start of year

Income

Taken

Year Return Growth after

fees

Pension pot

at end of year

2008 5.7% £100,000 -£7,500 £4,304 £96,804 2009 1.0% £96,804 -£7,500 -£28 £89,276 2010 0.6% £89,276 -£7,500 -£365 £81,411 2011 0.6% £81,411 -£7,500 -£268 £73,643 2012 0.6% £73,643 -£7,500 -£235 £65,908 2013 0.5% £65,908 -£7,500 -£296 £58,112 2014 0.5% £58,112 -£7,500 -£256 £50,356 2015 0.5% £50,356 -£7,500 -£211 £42,645 2016 0.4% £42,645 -£7,500 -£201 £34,944 2017 0.3% £34,944 -£7,500 -£198 £27,246

Note: Fee assumed 1% p.a.; cash return based on JPM cash 1 month UK index.


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To make your pension pot last longer you need your investments to grow and that probably means keeping

at least part of your money in company shares. Table 2 shows that if you’d invested the same £100,000

pension pot in UK company shares ten years ago and taken the same level of income, you’d have benefitted

from a rising stock market and would still have £48,000 left today.

Table 2: Simulated pension drawdown investing in UK Company Shares, 2008-2017

Pension pot at

start of year

Income

Taken

Year Return Growth after

fees

Pension pot

at end of year

2008 -29.9% £100,000 -£7,500 -£28,609 £63,891 2009 30.1% £63,891 -£7,500 £16,420 £72,811 2010 14.5% £72,811 -£7,500 £8,827 £74,137 2011 -3.5% £74,137 -£7,500 -£2,972 £63,665 2012 12.3% £63,665 -£7,500 £6,349 £62,514 2013 20.8% £62,514 -£7,500 £10,897 £65,911 2014 1.2% £65,911 -£7,500 £104 £58,515 2015 1.0% £58,515 -£7,500 -£11 £51,004 2016 16.8% £51,004 -£7,500 £6,853 £50,358 2017 13.1% £50,358 -£7,500 £5,185 £48,042

Note: Fee assumed 1% p.a.; UK equity return based on FTSE All Share Index including dividends.

3. Are you taking the right kind of risk?

Large losses early in retirement can have a very negative impact on your ability to sustain an income for as

long as you’d like to. Investing a £100,000 pension pot in UK shares just as the financial crisis hit ten years

ago, as we assumed in the example in Table 2, would have exposed you to a severe 30% drop in the first year

(2008), wiping £28,000 off the value of your pension pot before you’d really got started.

To illustrate this point Table 3, below, shows what would have happened if you’d benefitted from exactly the

same investment returns as in Table 2 but with the 30% drop in share prices coming in the final year and

not at the start. You would have had £88,000 left over after ten years, and not £48,000.


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Table 3: Simulated pension drawdown if the 2008 loss had come at the end

Pension pot at

start of year

Income

Taken

Year Assumed

Return*

Growth after

fees

Pension pot

at end of year

2008 30.1% £100,000 -£7,500 £26,934 £119,434

2009 14.5% £119,434 -£7,500 £15,128 £127,062

2010 -3.5% £127,062 -£7,500 -£5,333 £114,229

2011 12.3% £114,229 -£7,500 £12,065 £118,794

2012 20.8% £118,794 -£7,500 £22,044 £133,338

2013 1.2% £133,338 -£7,500 £224 £126,062

2014 1.0% £126,062 -£7,500 -£25 £118,537

2015 16.8% £118,537 -£7,500 £17,492 £128,529

2016 13.1% £128,529 -£7,500 £14,641 £135,670

2017 -29.9% £135,670 -£7,500 -£39,642 £88,529

Note: Fee assumed 1% p.a. * Return for 2008 shown as if it happened in 2017 with other annual returns shifted back a by year.

This makes sense if you think about it. Large losses early on when the pension pot is at its largest mean you

have lost more money in pounds sterling terms and this limits how long you can take an income. Later on,

when the pot is smaller, the same percentage loss entails a smaller loss in pounds sterling terms and so it

has a smaller impact on your ability to draw income.

The importance of avoiding large losses early on argues against investing the whole pot in company shares

as they can see significant year to year swings in price. It also argues against taking excessive risk in the

hunt for income. As an example, there are investments linked to aircraft leasing or peer to peer lending

today that offer yields of up to 8% a year. On the face of it, you could take an £8,000 income on a £100,000

pension pot forever without ever touching your capital. Beware. There is no such thing as a free lunch.

Interest rates on safe investments like government bonds or bank accounts are very low today. If someone

is offering you a very high rate of interest, the capital may be at greater risk than meets the eye. If at some

point interest rates were to rise back to where they used to be a few years ago or if the world economy were

to go into one of its periodic recessions, you might find yourself with an unpleasant surprise.

There’s a tension here. If don’t take enough risk, there’s no way your money can grow enough to sustain a

reasonable income long into retirement. On the other hand, if you exposure yourself to the risk of large

losses early in retirement, you could end up in the same place with the money running out unexpectedly

early.


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Chart 3: A well-diversified multi asset portfolio

For most people the right approach will be to aim for steady growth but to reduce risk by spreading

investments across a range of different investments including company shares, bonds and property, both at

home and abroad as shown in Chart 3. An active manager can vary the proportions held in each type of

investment with the aim of incrementally increasing returns while reducing losses in poor market

conditions.

4. What is a reasonable level of income?

A multi asset approach can help to grow your pension pot so you can sustain a reasonable level of

retirement income while reducing losses in poor market conditions. By blending different assets classes in

varying proportions a risk-rated range of funds can offer several options, from a relatively stable mix one

step up from cash to a portfolio aiming for returns coming closer to those on offer from company shares but

with less short term volatility.

We explored the sustainability of retirement income assuming a pension pot of £100,000 was invested in

one of two multi asset funds:

1) A ‘Defensive’ fund with 25% of its assets in higher risk, growth-seeking investments like company

shares, commercial property and commodities and 75% in less volatile sterling bonds and cash.

2) A ‘Growth’ fund with 75% in the growth-seeking assets and 25% in bonds and cash.

Source: RLAM and Moody’s Analytics; % allocation to different asset classes

using an illustrative risk targeted benchmark.

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80

90

100

OLD NEWTraditional Increased diversification 0

10

20

30

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50

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90

100

OLD NEWTraditional Increased diversification Increased diversification


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We investigated two different income requirements. A high income of £7,500 a year, in line with where

annuity rates used to be 10 years ago, and a more moderate income of £4,500, consistent with the lower

annuity rates available today.

In order to simulate what might happen in a wide range of investment outcomes we conducted 10,000

realistic simulations consistent with the risk and return characteristics of the two fund options, as shown in

Panel 1. The return assumptions are conservative, as is required for pension illustrations, and include no

allowance for additional returns that could come from active management.

Panel 1: Simulating income sustainability based on different income and fund choices

Note: Calculations are in line with ‘mid-range’ growth rates as required by the Financial Conduct Authority for pension illustrations.

Perhaps unsurprisingly, the results were poor when looking at the £7,500 income requirement (see Charts

4 and 5). With either fund choice, we found that the income level was very likely to be sustainable for the

first ten years from retirement, as shown on Chart 4, but after that point there were an increasing number

of scenarios in which the money ran out. Returns averaging 2.5% or 4.3% per annum were simply not high

enough to keep the pension pot topped up with an income of 7.5% of the initial pension pot going out every

year. The fall off was particularly marked for the Defensive fund, shown in purple, with the money lasting

less than 15 years in more than half of the scenarios. The Growth fund fared little better. There were some

instances where good returns helped the money to last 20 years or more but the money still ran out in 15

years or less about half of the time.

• Starting pot of £100,000

• Two income requirements

• High: £7,500 per year

• Moderate: £4,500 per year

• Two multi asset portfolios with different risk/return characteristics

Defensive Portfolio Growth Portfolio

Expected Return 2.5% 4.3%

Expected Volatility 4.5% 10.5%

Fees (p.a.) 1% 1%

Source: Assumed mid growth rates for pension illustrations based on GP3/GMAP Defensive and GP5/GMAP Growth

• Is INCOME sustainable and can we leave some money for inheritance?


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Chart 4: Income sustainability Chart 5: Average projected pension pot

We found a £4,500 income requirement to be much more sustainable. This time, the money lasted more

than 25 years in more than half of all scenarios, whichever fund you used, as shown in Chart 6. Better still,

the value of the pension pot, shown on Chart 7, held up well. With the Growth fund, we found someone

living 25 years after retiring would, on average, be able to pass on a pension pot worth about £20,000 in

today’s money.

Chart 6: Income sustainability Chart 7: Average projected pension pot

We have included the profile for a typical annuity in black on Charts 6 and 7 for comparison purposes. On

the plus side, the income from an annuity is guaranteed to continue no matter how long you live. However,

the value of the pot you can pass on to the next generation falls off very rapidly indeed. Typically annuity

payments are guaranteed to continue for a minimum of five years but after that there’s often nothing left.

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5. Conclusions

The 2015 pension freedoms changed the way we take income in retirement. No longer having to buy an

annuity at retirement has increased flexibility enormously but the freedoms mean people now have to work

out how best to make their pension last to avoid running out of money in retirement.

It goes without saying that your retirement income won’t last as long if you take a lot of money out of the

pension pot early on. An income of £4,000 to £4,500 a year on a typical pension pot of £100,000 should be

sustainable long into retirement but it is important to ensure you are taking enough investment risk to

generate growth over what could be a long period of time. It is also important to avoid excessive risk as

large losses early in retirement can have a very damaging impact on the sustainability of your income.

For most people the right approach will be to aim for steady growth but to reduce risk by putting your

money into a multi asset fund that spreads investments across a range of different investments including

company shares, bonds and property, both at home and abroad.

A drawdown pension gives you much greater flexibility than an annuity and offers a higher likelihood of

having something of value left to pass on to the next generation when you die but you do need to keep your

finances under review.

Retirement is a journey. There are hidden dangers in choosing the right investment strategy and in deciding

the appropriate level of income to draw out. A financial adviser should be able to conduct a regular

assessment as to the sustainability of your retirement income and help you make any necessary

adjustments in order to help you make the most of the pension pot you have built up over a long working

life.

Disclaimer:

This paper is intended to provide helpful information but does not constitute financial advice. Issued by

The Royal London Mutual Insurance Society Limited in January 2018. Information correct at that date

unless otherwise stated. The Royal London Mutual Insurance Society Limited is authorised by the

Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential

Regulation Authority. The firm is on the Financial Services Register, registration number 117672.

Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V

0RL.

ROYAL LONDON POLICY PAPER 18 Avoiding Hidden Dangers in ...€¦ · pot so you can sustain a...

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