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Focusing on cash is not a good idea when building long-term savings. In 2021, interest rates are so low that even a 1.7% fixed-rate savings account with a High street bank fails to beat the 2% target rate of inflation set by the Bank of England (BoE). The stock market offers the chance of producing far better returns (with the right strategy). However, one advantage that cash has is that it remains fairly constant – setting aside inflation – and you can expect the balance to be the same in 5, 10 or more years when you come to withdraw it.
The stock market and other assets, however, are variously more volatile. By the time you want to convert these into money to fund your retirement lifestyle, for instance, they might have gone down in value. This is known as “sequence risk”. A common question posed to us at Elmfield, as financial planners, is how to navigate this effectively – especially as someone nears a chosen retirement date. In this article, we offer some thoughts to help readers understand this better.
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Today in 2021, most workers need to now take primary responsibility for how the investments in their workplace pensions perform. Previously, this was not the case. Many employers enrolled their staff on final salary (or “defined benefit”) pension schemes which pay out a guaranteed, lifetime income in retirement – often also linked to inflation. Therefore, if the investments in the pension scheme underperformed, the onus is on the employer to make up for any shortfall in the ex-employees income from the scheme.
Today, however, whilst some employers (e.g. the police) still offer such schemes, most workers in 2021 will be enrolled on a defined contribution pension scheme. This involves building up a pot of money with your employer, where you put in a minimum of 5% of your salary and they contribute at least 3% (in 2021-22). The contributions to the pension scheme are mainly put into funds comprising equities, bonds and other investments. These may go up or down over time. By the time you want to retire, the value of your retirement savings may have gone up by a lot. Or, they may be lower than you expected – perhaps due to a recent stock market crash. This happened in 2020, for instance, when equities fell in the wake of the spread of COVID-19 – leading many pension funds to lose as much as 25% of their value in the second quarter (Q2).
Stability from the state pension
One way to ensure a good level of financial stability in your future retirement is to invest in your state pension. In 2021-22, the full new state pension provides £179.60 per week (or £9,339.20 per year). Currently, this income rises with inflation, wages or by 2.5% (whichever is highest) under the “triple lock” system – helping to ensure the income continues to meet the rising cost of living in the UK. Moreover, the income from the state pension is not linked to the stock market because it is largely funded by general taxation. To get the full amount, you need at least 35 years of qualifying national insurance contributions on your record.
Adjusting strategy with age
Although the state pension is helpful, it cannot provide enough income for most people for a comfortable retirement. You will likely also need your own savings and investments to make up for the rest. Investments, however, can fluctuate in value and potentially be down by the time you look to take from them. How do you address this “sequence risk”?
A few strategies can help here. Firstly, you can discuss “de-risking” your investment strategy as you approach your retirement date. This involves steadily moving assets away from volatile investments (with higher growth potential) such as stocks, and more towards lower-risk assets such as fixed-rate securities (e.g. UK government bonds). Whilst these provide a lower rate of return, they also typically carry less risk to your capital. As your focus moves towards a wealth preservation goal as you near retirement, it can often make sense to discuss this move with a financial adviser to find a suitable way to do this.
Another strategy is to determine your “sustainable rate of withdrawal” – i.e. how much can you safely withdraw from your pension, over time, without eroding your portfolio too much or even running out of money? Here, you might establish a number with your financial adviser (e.g. 3% per year). Or, you might decide to reduce your withdrawals during periods when the markets fall or crash. Here, you will need to ensure that you can still meet your monthly retirement expenses on a lower income.
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938