Longevity has increased steadily in OECD countries and it continues to undermine the foundations of pay-as-you-go pension schemes, which, in recent years, have reacted by increasing the age at which scheme members will retire. In 2012, the average length of their retirement was 18 years for men and 22.5 years for women in OECD countries, an increase of around eight years since 1970.
Exhibit 1: Number of years in retirement for women and men between 1970 and 2012
Source: OECD, 2013
This makes the issue of funding for one’s retirement even more difficult by requiring individuals to save more during the accumulation phase. It also raises the question of how best to use one’s accumulated savings upon retirement. Several solutions exist, the following being among the most commonplace:
1. Keep one’s savings in short-term ‘secure’ investments so that withdrawals are possible whenever they are needed:
o Advantages: liquidity and no capital risk
o Disadvantages: no protection against inflation; a clear risk of losing purchasing power (interest rates are currently negative below a maturity of five years)
Exhibit 2: Interest rates paid by French sovereign bonds/debt instruments.
|Term||3 months||6 months||1 year||2 years||3 years||4 years||5 years||6 years||7 years||8 years||9 years||10 years||15 years||20 years||30 years||50 years|
|French gvt. bond rate||-0.097||-0.099||-0.098||-0.095||-0.083||-0.029||0.047||0.116||0.216||0.31||3.39||0.536||0.942||1.129||1.388||1.56|
Source: Bloomberg as of 10/05/15
2. Buy an annuity:
o Advantage: securing a known amount of monthly income for yourself and possibly also for your partner.
o Disadvantage: depends, among other factors, on the level of interest rates (and inflation) at the time of the annuity purchase; the current low interest rate environment is distinctly unfavourable.
3. Invest in assets that generate income
o Advantage: possibly receive a higher annual income than that of ‘risk-free’ assets, due to exposure to risky assets that pay coupons (bonds) and/or dividends (shares) or income (property, listed or non-listed); generally provides protection against inflation.
o Disadvantage: higher or lower performance of this type of investment comes at the price of higher or lower volatility and thus a risk of capital loss. Asset management offers solutions including risk management that can reduce (although not eliminate) this disadvantage.
This type of solution has a role to play in the allocation of assets for savers.
4. Plan future requirements and invest savings in target-date funds with lengthening maturity horizons covering all or part of your expected retirement period.
o Advantage: allows for fine-tuning of risk depending on each individual’s predetermined investment horizon;
o Disadvantage: even if the target date funds include risk management (reducing the allocation to risky assets as the fund approaches the maturity date), high financial market volatility may occasionally have a negative impact on the performance of these funds
o Alternative: using target-date funds with partial capital protection can provide greater visibility on how much capital will be available in the future.
To sum up, an optimal solution for decumulation probably involves a combination of the tailored solutions outlined here, based on each individual’s future needs. Nevertheless, there are some rules to be respected:
– Accumulated capital is not all spent on the day we retire.
– So it makes sense to plan for one’s needs over time.
– Such planning can ensure a more rational allocation of savings. Indeed, it allows an individual to continue taking risks with that part of their capital that may not be needed until sufficiently far in the future for it to be used in seeking to capture the risk premiums on risky assets.
All this should be done within an optimised tax framework. This can have a significant impact on performance of investments and inheritance issues.