Sitting next to Steve Bee, my ex-colleague and the original pension guru, I was reminded of a short story by Somerset Maugham entitled The Lotus Eater. I had originally read it at his suggestion and found it to be the perfect illustration of the problem facing retirees from DC pension schemes – how to make your money last exactly as long as you do.
On the face of it, all that needs to be done is to calculate how long a person will live, then divide the value of their pension pot by this amount. This is exactly what Thomas Wilson does in the story. The problem is he got the first bit wrong. Having decided he would live for exactly 25 years, he then found that he was still alive after that and wanted to remain so. As a result he found himself with no money and entirely dependent on the charity of others.
This might seem extreme, but the reality is that many people plunge into retirement without any clear idea of how much income they can take from their pension plan without running out too soon.
Key points
- The average life expectancy at the age of 65 is 21 years for men and 23 years for women.
- Most clients will live longer than that due to their wealth and lifestyle.
- A pension fund of £250,000 might look huge to most people, but looks a lot smaller if it is spread over 30 years.
How can advisers solve this problem, other than by persuading clients to be more resolute than Mr Wilson and putting an end to their existence at exactly the right time?
The answer is, of course, that we cannot. We cannot be sure when they will die, and we cannot be sure what will happen during the period between retirement and death. We can, however, make some fairly good estimates, which can make it considerably more likely that our clients will get closer to their target than poor Mr Wilson.
1. Estimate life expectancy
Recent ONS figures show that the rate of improvement in life expectancy is slowing, but it is still improving. That is good news in any other circumstance than when your pension is running out.
The average life expectancy at the age of 65 – still the most common age at which people start to take benefits – is 21 years for men and 23 years for women. But this is an average, a statistical concept and not a reflection of any real person.
By definition, about half of the people who reach age 65 this year will live longer than the average and about half will not survive as long. You cannot be sure which group any client will fall into. However, there are factors that can help you to make a reasonable estimate.
Longevity is strongly linked to lifestyle, health and wealth. Financial advisers dealing with retiring clients should consider that they are more likely to be in the longer-lived group simply because they are clients and therefore likely to have more wealth and, hence, health and a good lifestyle. Unless there is a good reason to the contrary, such as pre-existing medical conditions or strong familial factors, it is safer to plan on the basis that a client will live longer than the current average. For a 65-year-old in good health a 30-year time horizon is not at all unlikely.
2. Distribute asset value across longevity
Having taken a view on life expectancy it is possible to create a picture of how much income it is feasible for a client to take without it running out. This is a vital part of the process, particularly since the Government Actuary's Department (Gad) income limits were abolished in 2015.
