How do you plan for the financial unknown?
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Financial expert Peter Sharkey says there are steps you can take to plan your future income.
In February 2002, US Secretary of State for Defence Donald Rumsfeld was lampooned rather too hastily after stating during a briefing that: 'There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. There are things we do not know we don't know.'
Those who were quick to criticise believed the statement was nonsense, which explains why none of them could ever be considered for the post of US Secretary of State for Defence, but even a cursory examination of the statement shows that of course it makes sense. Indeed, the concept of an 'unknown unknowns' existed among scientists long before Donald Rumsfeld gave it a new audience.
Though Mr Rumsfeld was talking about US defence-related matters, those of us who have reached the stage in life where we're starting to be inundated with pension- and 'senior'-related advice and material as we career towards what we trust will be a prolonged retirement, recognise that his comments apply equally to our situation.
For instance, we know that at some point we shall shuffle off this mortal coil, one of life's guaranteed, 'known knowns'.
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Conversely, No-one knows when their maker will call them away; in other words, this is something we know we don't know, although we hope this particular known unknown is many years away.
Let's ignore unknown unknowns for now and consider the impact of Mr Rumsfeld's first two propositions on pension planning. In particular, although none of us have any idea how long we have on Earth, it makes sense to calculate how much we could draw from a pension pot over a defined period. The Which website calculates how long pension pots will last once provided with a specific drawdown figure as the chart shows.
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The example assumes a yearly increase of 2pc in the amount withdrawn with the pension pot invested across three areas: cash, which enjoys annual growth of 0.5pc; fixed interest, which grows at 4.75pc, plus a stocks and shares element growing at 7.25pc, a figure that looks a tad optimistic. Nonetheless, the calculations provide an idea of pension pot longevity and highlight how, by withdrawing a slightly lower sum, retirees can squeeze more from their retirement fund over a longer period.
How would these figures look when selecting our own investment growth rate, say 3.5pc a year?
A 63-year-old, retiring with a £400,000 pension pot and withdrawing £25,000 annually would, assuming growth of 3.5pc, have enough to last until the age of 86. If the annual withdrawal was reduced to £20,000, the pot would last for 34 years – ie until the age of 97.
Of course, that great known unknown, life expectancy, must be taken into account.
For instance, a male scheduled to retire in four years at the age of 65 could expect to live, on average, for a further 20 years. If he has a pension pot of £400,000 and withdraws £20,000 annually, there would still be more than £200,000 in the pot when he died, a scenario likely to suit very few people, although this example does assume punchy annual investment growth of 5pc.
Withdrawing £20,000 from a retirement pot is not, however, likely to guarantee a life of luxury, unless it is supplemented with the state and/or an employer's pension. A Which survey found that on average, a couple needed an annual minimum of £18,000 on which to live. The organisation suggested that a slightly more comfortable retirement, which included luxuries such as European holidays, would require £26,000, while a 'luxurious' retirement, with regular long-haul holidays and a brand new car every five years would cost a couple £39,000 a year. Bear in mind these are today's figures, net of tax and take no account of future inflation – yet another 'known unknown'.
Estimating future income as well as our likely longevity is ultimately an exercise laced with reasonable assumptions, 'guesstimates' and constant reminders of our mortality. But this shouldn't deter us – provided we steer clear of including unknown unknowns.
TAM Asset Management Ltd offer investors the opportunity to avoid unknown unknowns by investing in a balanced ISA portfolio from as little as £25 a month. For further details, please visit the MoneyMapp website.
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For more financial advice, check out Peter Sharkey's regular column, The Week In Numbers.