01 Jul What is an adequate retirement income?Read Time: 4 minutes
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A recent report published by the Pensions Policy Institute seeks to address the question of what constitutes an adequate income in retirement. The authors recognise that the definition of adequacy varies according to perspective.
For example, from the point of view of the state, the objective might be to avoid dependency on means tested benefits. For an employer, providing benefits to employees might be seen as a valuable part of its offering to attract good quality candidates or alternatively, as simply another cost of having employees. However, what is of most interest to me is the perspective of the individual as it is principally individuals to whom we provide advice. From the individual’s perspective, adequacy is normally taken in the context of their ability to maintain their living standards once they are no longer engaged in paid work. Naturally, this varies according to what their living standards already are. It is also not inevitable that they are directly correlated with their income.
I’d also take issue with the title of the paper (and, by extension, of my own blog!). There is more to supporting lifestyle in retirement than a need for income because not all of our expenditure needs are of a regular nature. The report does recognise this but with capital needs varying between individuals even more than regular ones, using income as a measure is a pragmatic solution.
Actually we prefer the term ‘financial independence to retirement. By that we mean the stage of our lives when paid work is an option, not a necessity. Many people continue to work after the point in their life when they need work to meet their expenditure needs. They may do this because they enjoy the mental challenge, they like the social interaction or they feel that it would be a waste of their decades of experience to do nothing with it. A friend who worked in the education sector has recently become a school governor in the village to which he moved for that very reason.
The authors identify to ways in which retirement income can be measured. One is in absolute terms, under which a figure is calculated based on the value of a basket of goods and services. They cite examples of a minimum (£16,536 for a couple), moderate (£29,100) and comfortable (£47,500) annual income as the basis of their calculations. These figures are for the UK as a whole and it should come as no surprise that in the south-east, these figures are higher.
The other is the proportion of the individual’s previous income that would be required to replicate their working life standard of living after they have ceased work. Clearly this approach has its origins in the defined benefit pensions regime, whereby individuals accrued benefits in the form of a fraction of their annual salary for each year of service. Depending on the structure of the scheme, individuals would typically be able to accrue a maximum of half or two thirds of their final pay after 40 years of service. However, relatively few current employees can look forward to such generous benefits, given the decline in the number of defined benefit schemes in recent decades.
Defined benefit schemes have been replaced in many instances by defined contribution arrangements, which tend to have less generous expected benefits and which transfer the risk of underfunding from the employer to the member. They also require the member to take a view on an appropriate investment strategy, a decision for which they may not be well equipped.
However, while it is unsurprising that the Pensions Policy Institute would produce a paper which focuses on pension schemes, it is important to bear in mind that there is more to meeting lifestyle costs in later life than pension schemes. Indeed, we advise a number of clients who have modest pension benefits, particularly as a proportion of their overall assets, yet are able to enjoy a very comfortable retirement by drawing on other resources. A pension scheme is simply a savings vehicle with tax benefits, even though these have been curtailed over the years as governments seek to control the cost of those tax benefits. Any study on income in retirement which limits its scope to pension benefits may therefore disregard the cohort of the population which has, for a variety of reasons, made its provision via other means.
As noted above, there is more to funding and adequate standard of living (however this is defined) than simply a regular income stream. Capital expenditures do not stop once paid work does and the authors recognise that while using income can be helpful in terms of benchmarking, at an individual level there may also be capital needs, whether provide additional flexibility or to meet capital expenditures. In addition, non-pension capital can be helpful in bridging the temporary gap between when someone ceases paid work and when their employer and/or state pension benefits commence.
They also report on a finding from New Zealand that retirement can be divided into three stages. These are identified as discovery (65 to 74) endeavour, (75 to 84) and reflection (85+). I have also seen these phases described by the less academic terminology Saga, Aga and gaga! In general, expenditure reduces across the stages, notably on recreation activities. Nevertheless, those experiencing failing health in the latter stages of life may find that it increases significantly if they need to fund the costs of care services.
In terms of the proportion of people currently approaching retirement (aged 50 to 65 in 2016/18) which is likely to achieve their goal of a comfortable retirement, the picture is not particularly encouraging. Allowing for both pensions and additional liquid capital (i.e. excluding property equity), around one in six can look forward to achieving this. Two out of five were on track for a moderate income while just over three quarters were expected to hit the minimum level. Although including property equity increases these percentages, it does not do so by a large margin. This may be a function of reduced home ownership as people rent for longer. The shortfall is worst for those in London and those on low incomes are also more likely to be in rented accommodation, so have ongoing housing costs for longer.
Using a proportionate measure whereby the target is two thirds of pre-retirement income, around two thirds of people are on target when pensions and other non-property assets are included. This measure may provide a better link to individuals’ pre-retirement standards of living which most would wish to maintain, subject to the caveat that not everyone spends that proportion of their income on items which will continue for the rest of their life. However, the two thirds target comes from the Pensions Commission, whose focus is naturally on pension matters and it may be that the proportion of earnings chosen is more reflective of the (somewhat arbitrary) maximum payable from defined benefit pension schemes.
Next time I’ll consider the options if you fall into one of the categories of people whose anticipated income falls short of their objectives.