BT: Time to redraw your retirement plan

Business Times - 14 Nov 2007

Time to redraw your retirement plan

Longer life expectancy and erosion of traditional pension schemes signal that retirees may outlive their assets, says KURT REIMAN

RETIREMENTS are becoming ever longer and more costly. Pensioners need to save enough to fund a comfortable life and to ensure they can leave assets to the next generation.

Retirement, in its current form, will soon be a thing of the past as demographic, financial and lifestyle factors lay siege to the traditional models. Pension plans, both public and private, face a squeeze from fewer people working and more people retiring. Meanwhile, medical and healthcare spending are rising, putting government finances under additional strain.

Yet most people expect to lead active and healthy lives during retirement, with some hoping to combine relaxation with a job, part-time or otherwise. Together, these trends are reshaping our thinking about careers and how to pay for what comes afterwards. Retirement, in short, is evolving into something completely new.

Traditionally - and particularly in places other than Singapore - retirees have relied primarily on government and corporate pension plans and think of their personal savings as an extra resource for additional or unforeseen expenditure. But the health of state-run pension programmes is under scrutiny, forcing individuals to take more responsibility for their well-being in old age. Against this background, living too long and spending too much have emerged as major risk factors. The latter hazard is accentuated by the ever more active lifestyle of senior citizens. If enterprising and adventurous pensioners want to enjoy their third age to the full, however, they need to ensure that their assets will stay the course.

Will I outlive my assets?

According to the United Nations, people born today in developed countries can expect to live 75.6 years on average, up from 66.1 years for those born in the 1950s. Moreover, today's 60-year-olds can expect to live even longer than these statistics suggest, having survived the high risk periods of infancy and early youth. Indeed, they might well live another twenty years on average, and this life expectancy continues to lengthen (see Figure 1).

Longer lives and the erosion of traditional pension schemes add to the danger that retirees will simply outlive their assets. So does the fact that life expectancy estimates have often erred on the low side in the past: that is, people have tended to live far longer than the statisticians have predicted.

All this increases the uncertainty surrounding the key question - how long they will live - that individuals need in planning for retirement. Nor do life expectancy forecasts account for the important differences stemming from gender, status, occupation, educational attainment, and country of residence.

If they rely on average life expectancy statistics, five people out of 10 run the risk of living longer than their assets will last. To mitigate that risk while they are still earning and saving money, investors would be best advised to calculate their retirement horizon conservatively (that is, by assuming a rather high life expectancy).

At the same time, they should factor in any relevant variables such as their physical condition and family medical history. A realistic perspective on one's personal life expectancy can go a long way to mitigating longevity risk.

Once they have accumulated the assets which will pay for their retirement, investors can also reduce that risk by purchasing an annuity, which comprises a series of payments of set size and frequency during the life of the holder. Although annuities are not risk-free - they are, for example, exposed to the hazards of inflation or the failure of the providing institution - they do ensure a constant nominal income stream regardless of how long the holder lives.

Demand for such instruments is on the increase as pension schemes become less generous. However, the amount of money that should be invested in an annuity remains a highly personal choice and it should always be borne in mind that committing assets to an annuity can reduce the amount of a portfolio that can be passed on to the next generation.

Will I overspend my assets?

The danger that one might live beyond one's means, also known as liability risk, is another increasingly relevant factor in retirement planning. It is linked to the fact that people are living longer and arises partly from the trend towards increased individual responsibility for healthcare. Additional factors include the growing taste for more ambitious lifestyle goals, such as frequent travel and staying young and fit.

There are numerous ways to reduce liability risk. One can continue to work longer or relocate to a country with a lower cost of living (see Figure 2). This also helps to reduce the chance that you will live longer than your assets last. Each extra year of spending that is funded from employment income represents an additional year that retirement withdrawals can be postponed and investments can continue to grow.

Another option is to limit the uncertainty related to future costs by purchasing elderly and long-term healthcare insurance. Without this insurance, individuals may need to plan for worst-case scenarios for healthcare liabilities, or face the prospect that healthcare costs will erode assets that would otherwise be passed on to the next generation. Individuals can also pay down debt before they retire in order to increase their net worth.

Mandatory v discretionary

needs When it comes to reckoning up the total income a retiree will need, expenses should be classified into mandatory and discretionary. Mandatory expenses are those related to basic daily needs, including housing (mortgages, taxes, and maintenance fees), food, and medical care.

Discretionary expenses are everything else, accounting for the remainder of the total income requirement.

To estimate how much income you might need, consider the things that you really cannot do without and the things you might be able to sacrifice or scale down. An apartment, for example, might be more convenient and cheaper than maintaining a house, and holidays at home might be less costly than travelling. Downsizing your lifestyle might be an option if you fear that your assets might melt away too soon. A solid estimate of your mandatory needs also helps you to determine the amount of assets that should be invested in an annuity, if any.

Figure 3 shows a hypothetical income and expense framework during retirement. Mandatory expenses are met with pension and annuity income, while discretionary needs are funded by assets allocated first to an absolute return portfolio. Other discretionary income sources could also include rental income, royalty payments, or other alternative income streams. Assets above and beyond these mandates are contained in a growth portfolio, which can be allocated in line with investors' longer-term goals.

When there is a high probability or desire to leave a bequest, assets can be allocated with the beneficiaries' time horizon in mind. Consider also that bequest motives require prudent estate planning; holding rapidly appreciating assets can significantly increase estate tax liability.

Review regularly

No estimate or forecast can be safely relied upon unless it is regularly reviewed in the light of changing economic, financial, regulatory, demographic, and personal circumstances. Without such a review, even the most finely tuned income scheme may quickly lose its relevance. It is important to keep track of realized investment returns, as well as expenditure, and to adjust spending habits and lifestyle as necessary. Retirees should, therefore, review their retirement plans regularly and discuss their plans with their client advisers.

Kurt Reiman is head of thematic research at UBS Wealth Management Research. He can be contacted at kurt.reiman@ubs.com