Retirement is the phase of life where your investment portfolio really comes into its own. No longer just a background number ticking upward during your career, it’s now a key driver of your lifestyle. Whether you’re looking for income or growth from your retirement portfolio, here are some of the most common pitfalls to avoid when investing for your retirement.
The stakes of investing in retirement are high, and I recommend that you seek financial advice if you feel it is needed to understand the risks and investments available to you. This article is not financial advice.
Investing mistakes made in retirement
1. Chasing too high a yield
Retirees will seek to maximise the income they can generate from a fixed pot of investments. Many retirees choose to live off whatever dividends and interest their portfolio can provide (supplemented by the state pension and any others). Therefore this maximisation strategy makes sense – the more income an investor can extract – the more money they can spend.
Here’s why you need to be wary of this logic trap. There is a natural ‘limit’ on the income an equity and bond portfolio can generate without becoming excessively risky. And that natural income yield is unfortunately quite low.
For example, look at the Vanguard FTSE U.K. Equity Income Index Fund, which at the time of writing, collects a dividend yield of 4.19% with an aggressive 100% equity allocation.
Therefore, attempting, as many retirees do, to invest for an 8% income yield is folly. It’s theoretically possible to create a portfolio that may deliver an 8% income yield. But the risk level would be so high that the portfolio value will suffer from high volatility and the income level will be prone to falling.
Ideally, your retirement investment portfolio will be a reliable machine that generates a sustainable income for the next few decades of your life. Unless you have substantial sums tucked away elsewhere, or a very reliable pension income on the side, your portfolio is not something you will want to risk altogether for the sake of increasing your income.
2. Being too conservative with cash
When we reach our retirement date, everything changes. It’s difficult to really grasp this twist in mindset until you step into the shoes of someone who has received a payslip for the final time.
Up until this point, money felt like an almost abundant resource. Sure, you were never overwhelmed by your pay, but if you looked vaguely into the future, you understood that there was ‘plenty more where that came from’.
On your retirement date, that mindset suddenly evaporates as the money tap switches off. Particularly for those retiring early before they qualify for state pension, the difference is stark. One month, you might be receiving £2,500 in your payslip, and the next month you’ll need to fund everything out of your existing savings.
Retirees understand that their pension pot is all they have left to support and provide for them for potentially several decades. If the pot runs dry, they will enter poverty. If a retirement investment account is mismanaged, even those who had wealthy careers could feel the sting of hunger before the end.
This concept of finite money supply and the risk of running out drastically changes the risk appetite of the individual. It won’t surprise you to hear that many pensioners actually withdraw from equities entirely.
The basis for a complete withdrawal is that this lowers the risk level to a point where the pensioner can have a high level of confidence over the interest income and withdrawals from their pension pot and chart a path through retirement which is unaffected by unknown market swings.
In other words, it helps give the retiree more control over their savings and gives clarity over whether drawdowns will be sustainable.
However, what you must appreciate is that a retiree at 60 may live until they are 80 or 90 – several decades into the future. When saving money to withdraw in 20 or 30 years time, the performance difference between a bank account and investing is incredible.
£100,000 saved in a 1% interest savings account for 20 years will grow to £122,000.
£100,000 invested in a 5% investment account for 20 years will grow to £265,000
At the same time, inflation averaging 2% per year will reduce the value of each pound by about on third over that period. This means that in today’s pounds, the £122,000 future savings pot is only worth about £81,000. In contrast, the future investment account pot would be worth £176,000 in today’s money.
Of course, these %s are only assumptions. A counter-argument would be that perhaps 5% is an optimistic rate of return on an investment account and that reality could play out in a bleaker fashion. That being said, the differential between the savings and investing route is so wide that investments would have to experience their worst two decades in recent history to perform worse than cash!
The irony here is that an investor would pivot from equities to cash to protect themselves from the risk of running out of money. In doing so, they are choosing the option which over the long term will almost certainly return the lowest possible sum.
3. Opting for annuities without considering the alternatives
For those retirees looking for a lower risk to align with their shrinking risk tolerance, annuities can be an attractive option.
An annuity is a risk-free monthly payment that will continue until you (and your spouse, in some cases) die. It’s a contract between you and a financial provider. What’s neat about an annuity is that the payment will continue even if you outlive all expectations and reach the old age of 105.
However, annuity providers are for-profit organisations and they cannot afford to promise a series of payments that will cost them more to provide than you are going to pay upfront.
Annuity providers will invest your lump-sum payment in a conservative selection of investments such as corporate bonds and government bonds. Most of the payment you receive each month will actually be your own principal amount being paid back to you. The interest or returns from the investments can help the annuity provider provide a premium on top, but they’ll also need to take a cut to cover their own costs and profit too.
Therefore, it’s helpful to visualise an annuity provider as an institution that takes over your bank account and slowly pays you a % of it back each year. If you die before the money in your account ran out, they can keep it as profit. If you outlive the money in your bank account, they’ll use the profits from early deaths to keep your payments going.
Two decades ago when government and corporate bonds paid reasonable rates of return (such as 2% – 5% per year), an annuity payment theoretically included a significant premium that came from these underlying investment returns.
Take a look at the stark change in annuity rates over the years:
In 2008, the Guardian reported that a male worker with a pension pot of £100,000, retiring at 65, could buy an income of £7,660 a year as an annuity. That’s a 7.6% annuity rate. A comparable rate offered today by Aviva comes to £4,669. That’s a fall of 40% in retirement income for someone retiring with the same pot.
Here’s the problem: annuity providers are extremely limited in how they can invest their funds. Due to regulation and the way they are governed, they are restricted to all but the safest of investments, to ensure that they do not suffer a shortfall between their investment funds and their annuity payment obligations.
But now that official interest rates have been close to 0% for over a decade, and the rates of return on quality corporate bonds are still extremely low, an annuity provider is getting very little yield at all on the underlying investments. All they can really do is feed your own money back to you.
Consider this; if an annuity provider was doing nothing other than setting your payment aside in a bank account and slowly drip-feeding it back to you, how long would the money last at a 4.6% annuity rate? It would take 22 years for the money to run out.
This implies that if you retire at 65 and you are quoted a 4.6% annuity rate, then you would have to live past 87 to even see any financial return beyond your own original annuity payment being paid back to you.
The Office for National Statistics states that a male at 65 can expect to live for 19 more years and a female 21 years.
Therefore I’ll let you make your mind up as to whether an annuity is a good investment while interest rates remain low.
However, as an individual investing for potentially decades, you may make the decision that you can take a little more risk. And that extra risk could add an extra 1% or 2% onto your annual portfolio performance. This might sound like a small percentage, but compounded over years this will make a lot of difference to your quality of life.
As a caveat – annuities are excellent products for those who have little desire, time or discipline to be happy investors. Many folks also worry that they’ll make an investing mistake or fritter away their fortune and therefore they like the security that an annuity income provides. It’s not always about maximising returns, yield and income. The ultimate objective is a peaceful and happy retirement after all. If a lower income is a happy trade-off for not having to worry about investments, then annuities might be the right choice.
To read more about retirement planning take a look at the retirement planning books in our ranking.