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Risky business

It has become clear in recent years that we are going to have to work longer in order to achieve the life we want. This is because we have insufficient funds to sustain us in retirement, Richard Watkins, Certified Financial Planner at Close Brothers Asset Management, looks at the prognosis.

The inescapable fact is, we are living longer and the mindset that pension funds and the state would provide for us has been undermined. Indeed, the concept of retirement is evolving as much as the way in which we work has evolved. Against the background of the abolition of the Default Retirement Age (DRA) and the need to plan careers and business succession could mean that staff may choose to stay with their employer for longer than they might otherwise have done. This may lead to a talent blockage and valuable staff may join the competition. This article examines the need for employees to take ownership of their finances and, by doing so, achieve the life they want and have a meaningful and mutually beneficial relationship with their employer. Research published in 2011 by The United Nations Department of Economic & Social Affairs 1 estimated that between 2015 and 2020 there will be more people over the age of 65 than under five. In Europe it is expected that the average person will live to their early eighties. Research published in 2009 2 showed that EU nations already had Euro 30 trillion of projected pension obligations to their existing population. In the UK in 2012 the ratio of people aged over 65 to working age was 25.9 percent. In other words there is one retiree for every four of working age. In Germany the ratio is closer to 1:3. In 2011, Unicharm, Japan’s biggest nappy manufacturer sold more diapers for adults than it did for babies, according to Bloomberg. The ECB estimated in 2006 that the pension burden of member states will account for 14.1 percent of GDP if there are no reforms. It is therefore not surprising that government look to reform the state pension neither is the trend towards closing entry to employer funded defined benefit schemes going to slow. The message is clear; we are responsible for our own welfare.

Research published by Close Brothers Asset Management 3 in recent weeks indicated that amongst the mass affluent 48 percent worry that they will not have a sufficient post-retirement income to meet their needs. Despite concerns over retirement income, nearly one in seven people have yet to make any provision for retirement, and those without plans do not expect to start saving until an average of 41. Deprioritising pension saving is costly. A 25 year-old saving £150 per month until retiring at 65 would see their future pension savings hit £295,285 by retirement. Someone saving the same amount from the age of 41 would accumulate just £96,956. This is a dramatic difference of £198,329 and the state pension is not going to cover the shortfall. In fact, just three percent of respondents are confident that the state pension will be sufficient to fund them in retirement.

Research published by BlackRock 4 clearly showed a marked misunderstanding of the corrosive effect of inflation and, particularly, a misconception of risk. Moreover, investors are only beginning to understand that, in a low interest rate environment, the size of their retirement pot that needs to be accumulated has become significant. By way of a broad indicator for every £20K of gross annual income we are each going to need about £660,000 of capital. Therefore, to overcome these challenges, it is first necessary to understand inflation and risk.

Inflation is a sustained increase in the price of goods and services. It is measured using a variety of benchmarks like the Retail Price Index (RPI) and the Consumer Price Index (CPI) to give an annual average rate. The current rate is 2.9 percent in the UK. Most people understand that the effect of inflation reduces purchasing power. If an item costs £1 today it will cost £1.029 in 12 months time. What the research shows is that depositors are happy to earn about 0.5 percent p.a. on their deposit account knowing that inflation will provide a negative real return of 1.4 percent p.a. because they do not perceive inflation as risk; the underlying capital has not visibly reduced. This is extraordinary; inflation is guaranteed to erode your savings whereas investment offers the opportunity of increasing your wealth. When set against research findings that 80 percent wanted to preserve wealth, build a nest egg, plan for retirement and draw an income from investments the risk adverse saver is not thinking clearly. This should be a cause of concern for employers.

Risk, in this context, is the chance that an investment’s actual return will be different than expected. This may include the possible loss of some or all of the capital. Risk is measured by analysing its standard deviation within its peer group. If you take on more risk then you will want additional return. Risk management strategies have been developed to help manage risk across a variety of asset classes by using asset allocation tools based on risk tolerance questionnaires. From this analysis you can calculate your risk and loss tolerance. This means how much value fluctuation you could put up with before it caused you a problem. There are four main reasons why people do not invest; risk aversion, a tendency to follow the crowd, attaching too much value to an item or investment and a tendency to react differently depending on how the information is presented. Investing is a risky business and it is not always successful. Doing nothing is a guaranteed fail.

To put the above into a real context each of us should do some homework of our own and it should start to make sense. Start by writing down all of your lifestyle costs, all of them, every single penny. Then create your own spreadsheet and project forward what your lifestyle costs could be in the future and at key dates you have identified. You will need to make an assumption about the annual rate of inflation. The outcome will be a vision of what your future may look like. Obtain a pension forecast from your provider as well as a state pension forecast and, if you have existing investments (exclude cash) you can forecast their values assuming a net return of, say, five percent p.a.

The alternative is to find an adviser who uses financial planning software like the example below. This will cost about £500£750 but could be more depending on what you want done. The forecast below is an example of such an exercise. In this case the married couple have decided to retire at age 60 in 2014. It is abundantly clear that they cannot afford to do so and will run out of money by age 73. The task is to correct the position. This article seeks to show how by contemplating your own financial future you can develop a plan to arrange an outcome you want, both employer and employee. This can be achieved through self education or by seeking advice from a financial planner or both. The benefits are numerous; financial independence if you plan ahead and are diligent and consistent; provision for your old age and/or your children. If you are able to picture your future you can evaluate the pattern of your career and work out what to do in between times. This could dramatically affect career choices and possible compensation solutions for the future. This also means that capable older employees may choose to provide mentoring services for younger, less experienced colleagues thereby relieving talent congestion, developing skills, reducing overheads and increasing employee satisfaction.

1 Name of The United Nations Department of Economic & Social Affairs research

2 Bloomberg, European Central Bank; impact of ageing on public expenditure published by European Commission 2006.

3 YouGov survey conducted on behalf of Close Brothers Asset Management between 23-30 May 2013 of over 1,000 adults in the UK with gross household incomes of £70,000 or more

4 Investor Horizons survey 13.09.12 to,000 individuals aged between 25 & 75 questioned

Richard Watkins, Certified Financial Planner
Close Brothers Asset Management

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