William John: I understand that a key part of your retirement planning help is in calculating how much you can withdraw from your investments each year...?
James Sumpter: Yes - the problem with a lot of the studies and theories, such as the those which gave rise to the "magic 4% rule", are based on rather short time periods. Between 1977 and 1997 there was a golden period of investment and you could really do no wrong in that time. The average real return between 1977 and 1987 was 12.5% and 1987-1997 it was 10.5% and during those periods the gilt markets returned 6% and 5%. This compares with the long-term real returns for equities which stands at about 4%, so if you retired at some point between 1977 and 1997 you could happily withdraw 4% and still be growing your portfolio.
But if you then look at someone who retired in the year 2000, they got hit twice inside 10 years. In the first 3 years of their retirement the stock market was down 50%, then it rallied until 2007 and then it was down by 50% again. If you were withdrawing 4% in that environment, you'd have no chance of recovering the value you lost, even with the good years we've had since 2010. In general you need a 7% annual real return in your portfolio in order to withdraw 4% per year and keep the amount your withdraw rising in line with inflation and maintain the same level of lifestyle.
Even in the good periods we've had since 2010, we haven't had an average of 7% return and therefore you'd be on a destructive cycle from which you can't recover.
William John: So you absolutely MUST take less out of your pot at points when the market drops, right?
James Sumpter: Yes - that's the key. If you happen to retire and get unlucky with the market, you simply have to accept that you've been unlucky and react accordingly. There are two ways to handle this sort of scenario: If you're able to do so, you should have a portion of money set aside in cash. The ideal amount would be 3-4 year's worth of expenditure to protect yourself against any kind of market drop, but not many people are in a position to have that much cash set aside. The only other course of action to survive the two falls in the 2000s without putting your portfolio into terminal decline was to reduce your withdrawals and then wait for those stocks to recover.
William John: And what percentage of their income do your average clients invest into the market during their working lives?
James Sumpter: This varies dramatically from person to person and also depends on what period of life they're in. A lot of people have a golden period of their lives when their children are finished with education and they're earning the highest salary of their careers. They have the most disposable income between the ages of 55 and 65 and that's when they can invest the most, especially if they have also paid of their mortgage. But there are risks to leaving investment to so late in your career. Firstly you miss out on a good deal of compounding in your portfolio and secondly you could be forced out of your job due to illness or market forces - employers often look to lay off their most expensive staff.
William John: So saving money when you're younger is a much better strategy, right?
James Sumpter: Yes, but it's really difficult because that's the time when you're under the most financial stress and expenditure, working their way up through the housing market and raising young children with whom expenses are high.
William John: Can we then run through different stages of life to find out what you would advise people to be doing to move towards the best wealth situation. Let's start with the retirement planning help you'd give a 20 year old.
James Sumpter: The first thing I would advise for a 20 year old is to maximise the pension contributions that you're offered from work: getting a bit of cash into a pension at that age can be very beneficial because you've got around 40 years of compounding ahead of you.
William John: Would you always focus on a pension fund or would you also be making personal investments outside of a pension?
James Sumpter: Pension funds should be your first port of call, especially as more and more countries adopt an auto-enrolment model. In most pension situations the company matches your investment pound for pound, and you'd be hard pushed to get the company to give you that in additional pay if you're not taking it in pension contributions. So if you can afford to do this, maximising your pension contributions is the best thing to do.
William John: Psychologically, just getting into the habit of saving and investing is a good idea at that sort of age, right?
James Sumpter: Yes - and especially in putting it into some investment vehicle which you cannot touch. ISAs are excellent, for example, but there is always a risk that you could raid them in later life to buy a new car or a house you can't really afford and that damages your retirement income. In the UK the pensions law ban you from taking money out until you're within 10 years of the state pension age, which means you're not going to be able to touch your money until you're 58.
Essentially the best retirement planning help I can offer you is to get the power of compounding working for you. A good example of how time in the market works for you is a UK investment product called a Junior SIP which allows parents to invest up to £3,600 each year in the first 18 years of their children's lives. If you were lucky enough to have your parents invest the maximum into one of these, it'll be worth around £1/2 million by the time you reach 58 years old.
William John: OK great - what if you were giving retirement planning help to a 30 year old? This is generally the time when people are looking to buy a family home and have children.
James Sumpter: That's right - the biggest problem we have with our clients is that they underestimate the risk of being under-insured. Admittedly the risk is slim that you're going to need to draw on life insurance, but most people are too reliant or put too much value in the life insurance scheme their employer provides.
For example, as part of my retirement planning help, I will often ask what a client would receive in the event of an incident that prevented them from working ever again. Typically the answer is that they will receive something like four times their annual salary. The better-prepared people I speak to have a policy in place to pay their mortgage as well and they think they're fully prepared for the future. But the problem is that if someone drops down dead at age 35 or suffers a life-changing illness, they're actually losing 25-35 years of savings and investments that they would otherwise have been able to make. You need to make sure that this is covered by insurance. A high earner saving £30,000 a year, dying 30 years before retirement age, should ideally have insurance to pay out 30x £30,000 = £900,000.
The plan offered by this person's employer that pays four times annual salary isn't going to give you anywhere near that capital sum. So the first thing we do when we offer a new client retirement planning help is to run one cashflow projection with a healthy life and another one in which the main income earner died tomorrow. We work out where your husband / wife and children would be a few years down the line with your insurance pay out compared with where you could reasonably expect to be if you continue working. And life insurance is very cheap - this could cost you around £50 per month to insure. In short, before you look at making investments, you've got to make sure you've got your extra income is insured and that you've made provision to pay off any mortgage you have on your home.
William John: What about a person in their 40s where they're probably in the house they're going to stay in until they perhaps downsize in retirement?
James Sumpter: At this point retirement planning help means doing a lot of cashflow forecasting. We look at what you're spending vs. what you're saving. In their 40s most people are still growing their earnings, but they are probably levelling out a bit. Sensible retirement planning help at this point means assessing whether each person's cash set aside for investing is sufficient to see them maintain their lifestyle after paying off mortgages and retiring. For example if you have £80,000 of post-tax income and you spend £50,000 per year, is the £30,000 you're investing going to be sufficient to keep you living the way you are now? These projections give you a pretty clear outcome. You can tell either that you're spending too much and not saving enough or that you need to increase your income. This can lead to people changing their strategy, either in curbing their lifestyle or in speaking to their boss to negotiate a higher salary. It also leads to a realistic discussion of when someone might be able to retire - for most people it's later than they hope!
James Sumpter: The biggest problem is that most people don't know accurately what they're spending. Most people who earn more than they spend don't actually know how much they're spending and saving. Firstly the expenditure is not fixed every year - some years you make home improvements, you buy a new car or you spend more on holidays, so it's a good idea to budget over 3-4 years and then average it out. From this you can then make a judgement about whether your expenditure is likely to increase, decrease or stay roughly the same. Then you have to think realistically about the level of earnings you're likely to have - for some people this is easier than others, depending on their job. A lot of our clients work in environments where their incomes are quite varied.
William John: What percentage of people have enough after your analysis, and what percentage are sadly deluding themselves?
James Sumpter: Before the age of 45, most people don't think about when they're going to retire and with what income and it's really not worth having that conversation with a client. Only when retirement becomes real to people is it worth seeking retirement planning help. By 45 most people are in their "forever house" they've made their decisions about whether they're going to have children and whether they're going to be paying high fees for their education. We can then start to make predictions because we know savings rates and make some assumptions about the growth rates of investments.
William John: What levels of growth do you assume?
James Sumpter: Like the investments, this is based on different strategies. Strategy 6 for example makes a growth assessment of inflation + 3%, strategy number 7 assumes inflation + 4%.
William John: That seems fairly conservative.
James Sumpter: Yes - it's based on looking at the historic numbers on our investment strategy performance and some forward-looking thinking about where we think various asset classes might go over the next 10 years. The general view is that returns over the next 10 years are likely to be lower than over the last 10 years. We think that monetary policies which have been adopted will lead to smaller returns and the fact that all asset classes currently look a little bit expensive. Emerging markets are the only things that historically look cheap right now compared with their long term average. Every 2-3 years we do a detailed review of our predicted returns. There is a certain degree of guesswork involved of course, but in offering excellent retirement planning help, we're looking for a realistic prediction - we don't want to tell a client they're going to get 7% above inflation and have it turn out that they only get 4%.
William John: What about for people who are in their 50s?
James Sumpter: This tends to be very similar to the process we go through with people in their 40s, except for the fact that you have more known quantities at that point, so you can make more accurate plans by that point.
William John: OK - give me the hard truth, James... Do most people end up retiring when they expect to and with the income they expect?
James Sumpter: Well that depends on what clients want to do. Most of my clients could probably retire 10 years before they actually do, but then I look after our highest-earning clients!
Most of us, though are going to have to work longer than we did before due to the demise of final-salary pension schemes in most sectors. Unless we have a final-salary scheme, we will have to save for ourselves and there is a serious chance that growth rates won't match what we had in the '80s and '90s. Also in the UK the government is changing quite a few of the benefits we had in terms of investing in and withdrawing cash from pensions tax efficiently. Therefore, I think that retiring at 60 for most people will not be a realistic ambition any more and we will have to work until our mid-sixties or early-seventies.
Retiring earlier than that is probably going to require a lifestyle decision even if you have a good income: It depends somewhat on the levels of necessary expenditure that you have, but beyond that it's a question of deciding what level of income you would like and when you'd like to retire. For most of my clients, necessary expenditure probably stands at about £25,000 per year, in other words that's the figure needed to pay for the costs of owning and keeping a home, running a car and feeding themselves and their families. Beyond that figure, it's a question of what lifestyle you're after: if you want to shop in Prada rather than Primark or go on holiday 4 times a year to exotic overseas locations rather than once a year nearer to home, then you're obviously going to need more income.
If you're someone who feels like they just want to give up work as soon as they can, then you might be happy to live on £25,000 per year in which case you're going to need a far smaller capital base than someone who is looking to live on £75,000 per year.
William John: Do many people look at downsizing their house in order to achieve the kind of retirement they want?
James Sumpter: Yes - that can and may need to be a key part of a lot of people's retirement plan. Downsizing to a house that's worth half the value of their current property can release a large capital sum. Advising on this sort of downsizing is part of the retirement planning help we offer. What people don't realise is that based on average rates of withdrawal of around 4%, releasing say £500,000 of equity from their house may not give them the huge increase in retirement income that they were hoping for (£20,000 per year). This is especially the case if they have a difficult first few years in the market immediately after retirement.
William John: Is 4% still the generally accepted figure for a sensible withdrawal rate?
James Sumpter: Yes - generally speaking - if you're getting a 2% above inflation return on your investments and you're withdrawing 4% per year, then your purchasing power is reducing by 2% per year and that's acceptable to get most people to the end of their lives, ignoring the potential damage of bad timing of your withdrawals; the decline of your income will be relatively gentle.
James Sumpter: The biggest risk in planning your retirement is timing: If for example your investment pot declines by 5% per year in the first 10 years of your retirement and the next 10 years showed growths of +15%, you're in big trouble even though the average growth over that period was good. This is because you had to withdraw cash in the first few years at the worst possible moment, and you're severely hurting the investment pot you have.
We in fact ran this as a case study - if you retired in 2000 with 60% of your investments in the stock market and 40% in the gilt market between 2000 and 2018 your average real return was 2.4% which sounds OK, but the problem was that the first 9 years were terrible and the next 9 years were brilliant. So if you had retired in 2000, you would have withdrawn considerable amounts of your investments in the first 9 years which would then not have been available to you to fund the next 9 years. If you had blindly withdrawn the equivalent of 4% of the starting amount, you would in fact have reduced your purchasing power by 70% over that period.
William John: What would have happened if a person in this scenario had a number of years' worth of cash saved away? How many years of cash would they have needed?
James Sumpter: Unfortunately you'd have needed a lot! I looked at the scenario of someone who had 3 years' of cash saved away who retired in 2000. I imagined a person with a £1 million pot at the start of the period who was looking to withdraw £40,000 per year and initially set aside £120,000 in cash to weather any upcoming storm.
They in fact were not in a much better position. Firstly they "only" had £880,000 to invest up front and therefore their returns were lower in the good years, and they had to sell considerable amounts of shares in the first few years when the markets fell, which depleted their pots even further. The net result of having 3 years of your pot in cash in this scenario was only 3.6% better than if you'd had no cash set aside. If you are unlucky enough to have extremely poor stock market returns in the first years of your retirement, you really have only one option and that is to accept that you will need to curb your spending to reduce the harm you do to your investment pot.