The best plan I’ve seen yet for securing your retirement income is to create a minimum income floor. This entails investing your pensionable assets in the safest financial products that can cover your basic needs for the rest of your life.
Anything left over is tucked away into your emergency fund and a ‘risk portfolio’ that’s tapped when you want to pay for life’s little luxuries.
It’s the retirement equivalent of hitting the casino with your play money in your top pocket but keeping your bus money strapped to your leg.
Floor in the plan
So how do you go about constructing a minimum income floor?
Firstly, the point of a floor is that you can’t fall through it. In other words, if you need £12,000 a year then your floor should always stand you that amount until you pop your clogs.
Secondly, the floor must be protected against financial dry rot:
- Inflation – This money-eating fungus can halve the value of your cash in a little over 20 years at the inoffensive rate of 3%, or in three years at a galloping 20%. And £12,000 per year is no good when it only buys you £6,000 worth of retirement. This is why most retirees don’t have the luxury of staying in the safest asset class of all: cash.
- Bad market returns – A portfolio of equities and bonds is too risky for a minimum income floor. There’s no way to be sure that a gruesome bear market won’t chew up your wealth and leave you unable to sustain your lifestyle.
- Bankruptcy – Banks, insurance companies, annuity providers and fund managers can all go bust. Retirement income products may need to last 30 years or more, so as ever it’s important you don’t place every egg in one smash-able basket.
Planks for the memories
So which financial products can form the planks of your income floor?
William Bernstein, investment advisor and scourge of Wall St, has narrowed the options down to three in his riveting book, The Ages of the Investor.
Option 1: Boost the portion of your floor covered by the State Pension
The State Pension is the best annuity around: an inflation-linked, government-backed income stream that will flow for the rest of your life. Money doesn’t get any safer than that.
You can boost your UK State Pension by deferring your claim. Every year of deferral increases your income by 10.4%. It can take a decade to recoup the cash forgone but it’s a good hedge against a long life.
Option 2: Build a ladder of index-linked government bonds
Again you’re inflation-proofed and putting your faith in virtually risk-free assets.
The key to not losing money on the deal is to buy individual index-linked bonds directly from the Government and hold them to maturity. As opposed to buying bonds in the secondary market or in bond funds.
As each bond matures it pays a portion of your income. All will be well provided you don’t live longer than the top rung of your ladder.
That whopping great snag aside – not to mention the miserable returns you currently get on index-linked gilts (also known as ‘linkers’) – this option is nowhere near as effective in the UK as it is in Bernstein’s America.
Here’s the problem: The fastest-maturing linker you can buy from the UK Government this year will pay you back in 2019. The next rungs on the ladder wouldn’t be reached until 2024 and then 2029. You’d receive income in five-year blocks that will be vulnerable to inflation until your next pay out day.
Option 3: Invest in a conventional, index-linked annuity
Inflation-protection? Check. Income guaranteed for the rest of your days? Check.
Risk-free? Nope. The annuity provider could go belly up, although there’s no modern precedent for this in the UK.
If the worst does happen then the Financial Services Compensation Scheme (FSCS) would cover you for 90% of the annuity. Ideally, you’d have a couple of annuities from different providers to prevent your income being totally disrupted by delays or even the complete malfunction of the FSCS scheme.
None of the options are perfect. The State Pension is too small, the linkers scant in supply and returns, and the annuity is only as good as the credit risk of an insurance company.
In my case, I’m currently helping a close relative secure her minimum income floor, and I think the best way to do that is by combining the State Pension with a conventional, index-linked annuity.
Here are the important numbers:
- £12,000 – my relative’s required minimum income floor (after tax).
- £10,000 – the tax-free personal allowance 2014-15.
- £12,500 – the gross income my strategy needs to deliver to account for tax.
- £3,500 – the amount of State Pension my relative receives.
- £9,000 – the income required from the index-linked annuity.
Happily my relative’s situation is relatively simple. There are no dependents to increase the cost of the annuity and niceties like leaving a legacy can be jettisoned in the face of nailing down her retirement income.
Yes, she has to cede control over the majority of her pension pot but I believe it’s worth it to ensure she’s as secure as possible from here on in.
Critically, there’s enough left over to form an emergency fund and to invest a small portion for future desires.
A level annuity would provide a much bigger income today and the greed demons kept whispering in my ear: “It’ll be fine, inflation will stay low, take the big bucks now.” I’ll explore how close a call this is in a future article.
But my job is to take as much risk off the table as possible, including the risk of the inflation genie escaping his bottle and going on the rampage.
That thought is enough to make me recommend the pure version of the minimum retirement income strategy. With the floor nailed down and inflation-proofed, it should endure through most of the disaster scenarios a retiree is liable to face.
Take it steady,