Working out the level of secure income to purchase with a pension pot used to be primarily the job of the people setting annuity rates. Now it’s primarily the job of the pensioner. Before pension freedoms, pensioners got, to a large extent, what they were given by the actuarial gods. Now, with extra options for how to use retirement savings, comes the extra responsibility to work out which options to choose, and to what respective degrees.
Choosing a level of secure income is still typically treated as a maths problem, with many retirees clamouring to know what the ‘right’ number is. But ‘right’ for what? Should they secure an income to cover all expenditure, or just the essentials? Or maybe it’s better to aim for a percentage of a former income stream? Or perhaps the answer should be calculated with reference to a cash-flow forecast?
The next layer of nuance, when it enters the equation, is also predominantly numerical. Secure incomes are of most benefit to those investors seeking to mitigate sequencing risk and longevity risk. This is partly those who are most likely to be financially affected by these risks (i.e. those that have high withdrawals relative to their investible assets and who wish to plan over a longer time horizon, or those with lower likely benefits of remaining invested instead, probably because of lower risk tolerance).
But it’s also partly those who are most likely to feel affected by them, who, even if they go to bed at night on the thickest financial mattress, are still kept awake by fears of running out of money.
Suitability is always a combination of the financial – the risk-reward of an investor’s portfolio, in the context of wider financial circumstances – and the behavioural – how an investment is perceived and the emotional comfort with which it is owned, in the context of the life it is ultimately serving.
Working out the suitable level of income to secure is no different. Which makes understanding some key dimensions of each potential income-purchaser’s financial personality a vital part of this particular suitability equation.
Investor personality factors that influence the suitable level of income to purchase
The key personality factors that influence the suitable level of retirement income to secure are:
Impulsivity: Impulsivity is an investor’s propensity to act quickly and on emotional instinct when making decisions about investments and – often more importantly – spending. This is the most relevant dimension of investor personality when determining the appropriate amount of income to purchase. Investors who are highly impulsive are less likely to: a) remain steadily invested through changing market circumstances (another personality dimension, composure, has a role to play here too); and b) control their own spending impulses. This means that they are much less likely to stick to plans, and more likely to withdraw beyond their means. In other words, more impulsive investors benefit more from being ‘locked in’ to an income stream that lessens their opportunities for reckless behaviour.
Composure: Composure is an investor’s tendency to get emotional with the present state of their investment journey (and also external stimuli such as the news). It’s a measure of an investor’s comfort or anxiety with the ups and downs along the journey. Locking in a guaranteed income is of greater benefit to lower composure investors because it reduces their exposure to market movements.
Financial comfort: Financial comfort is an investor’s confidence in and satisfaction with their long-term financial situation. It’s relevant here in that lower financial comfort means more worry about the portfolio being able to fund the future, and thus the suitability of greater guaranteed income.
Spending reluctance: Spending reluctance is the level of discomfort or anxiety an individual experiences when making purchases or planning future expenditures. It is closely associated with the Fear of Running Out, where people worry about depleting their financial resources with adverse effects for their futures… potentially decades down the line.
Risk tolerance: Risk tolerance is also a dimension of an investor’s financial personality. Its role here is chiefly in determining the extent of the additional benefit (or lack thereof) of staying invested. Those with lower risk tolerance and consequently lower long-term expected returns will have a higher benefit from a guaranteed income, and vice versa.
At Oxford Risk, we’ve developed not only robust and reliable assessments of each of these (and over a dozen other) dimensions, but also a methodology for quantifying and combining these factors to input into the retirement-income suitability equation.
This methodology further combines the investor’s personality with their circumstances, to arrive at a scientifically grounded recommendation for the right level of retirement income to secure for a given investor at a given point in time.
The key circumstances include:
The ratio of investment withdrawals to investible assets: The ratio of investment withdrawals (both ongoing and one-off cash needs) to investible assets determines an investor’s sensitivity to sequencing risk and longevity risk. The higher the ratio, the harder it will be to recover from a bad run of returns at the beginning of the withdrawal period, and therefore the more suitable it will be to secure a higher level of guaranteed income. The higher the expenditure (for the same amount of investible assets), or the smaller the amount of investible assets (for the same level of expenditure), the greater the need for a guaranteed income (up to a point, of course: if expenditure needs are too large relative to investible assets then no amount of either guaranteed income nor investment risk will solve your problem. You need to lower expectations and spending).
Age and health: Younger and healthier individuals (all else being equal) are likely to benefit more from a given guaranteed income, both because they’ll draw the income for longer, and because they’re more likely to benefit from the higher long-term portfolio values that come from their increased capacity to take risk. However, younger and healthier individuals get offered lower income rates by the actuaries than older investors in the same financial position. These two effects both need to be considered in arriving at the appropriate personalised guaranteed income amount.
Portfolio review frequency: This relates to sequencing risk, longevity risk, and psychological benefits. Where the investor and their adviser are able to regularly review changing circumstances, the need for a larger and earlier guaranteed income is less important, because they are in a better position to adapt the income (which, once bought, is for life) to changing, or clearer, needs. This is not about clients with a stronger advisory relationship needing less of a guaranteed income – it could be that a client could have a very frequent review schedule and a very high income. It’s simply that if you’re less frequently engaged in reviewing your situation, it’s prudent to be a bit more cautious. If regular suitability reviews aren’t possible, it would be prudent to purchase a higher guaranteed income ahead of time to protect against the sequencing risk of multiple years of poor performance before the situation is reviewed properly.
Planning without personality isn’t planning, it’s hoping
Securing a retirement income can be an irrevocable, lifelong, decision, and yet typically there is no robust, repeatable, methodology to guide that decision.
The suitability of this strategy is not purely a mathematical calculation. The idiosyncrasies of each investor’s financial personality (particularly their impulsivity) could – and often do – have a crucial role to play. The suitability assessment methodology must, therefore, account for this.
Greg B Davies, PhD, is head of behavioural finance at Oxford Risk
