When they get to retirement, many people still think in terms of risk and return when they should be thinking in terms of income. Visualising this wrong could lead them to favor the wrong assets.
“Workers have long been encouraged to take an accumulation mindset as they focus on growing their account balances in preparation for retirement,” a recent study by the National Institute on Aging says.
“[This can make] it difficult to switch mental gears to the decumulation mindset when transitioning into retirement.”
For its part, the retirement “industry” encourages this mindset through through three pillars: state provision, including the state pension, workplace pensions as mandated by auto-enrolment legislation, and private savings accounts in the form of self-invested personal pensions (SIPPs) or ISAs.
As a result, savers tend to focus on how they build this picture, rather than how they necessarily draw it down or reinvest for income.
The Reason to Save
Crucially, this framework pushes retirees to focus on short-term risk and return rather than lifelong consumption, in which savings are seen as investments rather than a source of income to sustain retirement. This leads them “to undervalue financial strategies that protect their financial wellbeing long after they retire—including choosing an optimal balance between their lifelong monthly income flows (to finance ongoing routine expenses) and accumulated savings (to finance any non routine expenses that arise).”
Spencer Look, director at the Morningstar Center for Retirement and Policy Studies, says:
“I agree that putting the focus on a monthly income amount is a good thing. Most of the time, [the] emphasis is on savings and balance, but it’s good to shift it to how much income it can generate against spending. This is something we’re talking a lot about in the US. Savings is not the key, but the amount of income you can create.”
Instead of thinking of these pillars, it may help to visualise a two-story bungalow.
In this construction, the foundation is built from different income streams: of government programs, pension funds, or annuities that are responsible for settling expenses like rent, heating, internet and phone costs, insurance, and healthcare.
Above that, the living space is then divided into “spending areas” covered by pensions and ISAs that pay for non-routine expenditures like travel, gifts, and renovations. And after these ongoing spending needs have been met, there is then flexibility to use the roof space to focus on non-routine expenditure, covering luxuries and expensive repairs.
Benefits to Reframing
“Reframing” retirement in this way is not just an intellectual exercise, however; it leads to tangible consequences. For example, an earlier study showed that moving from an investment to a consumption framework caused the share of participants who preferred having guaranteed income (like that provided by an annuity) to increase from 20% to 70%—versus holding money in a savings account. But they also show greater receptivity to many other avenues that were previously underrated, like considering one’s home equity as a potential income stream.
With the bungalow model, investors can also layer their portfolio quite differently too. On the first foundational layer, they might invest in very conservative assets that ensure a steady and secure revenue stream. On the top layer, Look suggests that, because their recurring expenses are covered, they can venture into riskier assets that deliver stronger returns, like growth stocks, commodities, and even liquid alternative funds.
A fixation on investment risks and rewards can also prompt other questionable decisions, like electing to receive a lump sum instead of a steady lifetime revenue. Unexpectedly, it can also lead to unfortunate choices. Look points to people “without a good retirement plan and who haven’t thought out their budget, who end up going to extremes, either spending too much of their savings too early in retirement, or saving too much … and dying a millionaire!”
This article originally appeared on our Canada sister site and has been re-edited to make it relevant for UK audiences
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