Decumulation, or ‘how to spend retirement savings’, is fast becoming the new talking point for DC schemes and IFAs with more and more members approaching retirement with a high proportion, or all, of their savings in a Defined Contribution pension scheme. The question for both the individual and the pension scheme then becomes, ‘how should this member spend their savings?’

Even for financially savvy individuals, this is a difficult and confusing question with many options available depending on the size of the pot and individual circumstances.

There are myriad ways to approach this problem and find a sensible solution for an individual to take their retirement income. Providers with retirement propositions need to find the best way to help consumers navigate this.  

The metrics in this article are generated through our GOPlan suite of APIs which use Hymans Robertson’s Economic Scenario Service to project cashflows in a stochastic world.

Set the scene

John is a 66-year-old with a DC pension fund of £150,000 (having already taken a small lump sum to pay for a holiday). He wants to take an inflation linked income via drawdown, using the investment strategy provided by his pension scheme, for 14 years and then purchase a single life annuity at the age of 80, which will provide a guaranteed income for the rest of his life.

The pressing question for John here is, what level of income can he take for the first 14 years of retirement before purchasing an annuity? Followed by; what level of annuity can he expect?

We’ve kept this example simple and excluded other sources of wealth like ISAs, LISAs and equity release for now. More on multi-product retirement strategy optimisation to come later though.

Sustainable Income

The level of income that John can expect can be calculated using our GOPlan Cashflow tool. This API allows the user to provide a set of member inputs, a variable input (known as the lever) and a specific likelihood that John can take this level of income each year, and not run out of money. The API will then calculate what level the lever should be set at to create a situation that will occur with the given likelihood.

John will want to be sure that his level of income is sustainable, meaning he doesn’t run out of money before purchasing his annuity. As such, he will want to choose a level of income that can be achieved with a high likelihood of success, say 75%. Passing this through our Cashflow Assistance solver gives the following results:

This means that with 75% confidence John will be able to take £6,977 each year from his fund, increasing with inflation each year.

The potential annuity income

John now has an idea of the annual income he can expect in retirement with a given success, but there’s a lot more that John might want to consider. Firstly, what level of annuity income would this then allow him to purchase at age 80?

The GoPlan Project tool can help answer this question. The GoPlan Project tool projects an individual’s retirement pot, allowing for any contributions into the fund and any income withdrawn from the fund. It can also provide a potential annuity income given the size of a pension fund in each year.

Assuming John starts with £150,000 and takes £6,977 each year (increasing with inflation) then at age 80, the Projection API gives the following potential annuity incomes:

The metrics

The figures above give John an idea about the level of income he can expect with a specific likelihood. However, he might want to look at what happens in extreme circumstances or what the general picture of his retirement income looks like. This is where the decumulation metrics become very useful.

The GOPlan Assess produces a number of useful metrics that characterise the portfolio in different ways.

The coverage ratio is the value in today’s money of the individual’s desired income divided by the value of their current retirement fund. So, a coverage ratio of exactly 1 means that the pot has precisely the amount of money to support the desired income. A coverage ratio of less than 1 means there is not enough money available in the retirement fund to cover your desired income, and a value greater than 1 means that there is more than enough money to pay for the desired income.

Because the calculations are stochastic and produce a variety of potential future scenarios we get a range of outcomes, from which we can calculate the likelihood that the pot will provide more or less than is desired. In addition, we can estimate by how much the retirement fund will exceed or fall short of the desired income target.

So, in the table below the 95% figure means that in 95% of outcomes, we’d expect John’s pot to provide enough income to cover 70% of his desired income, or better. Another way to think about this is that there is only a 5% chance (for example, if the financial markets perform very poorly) that John’s retirement fund will cover less than 70% of his desired retirement income. At the other extreme there is a 5% chance (for example, if markets perform very strongly) that John’s retirement fund will cover his retirement income by nearly 4 times!

The coverage ratio is a useful metric because it can quantify how bad (or good) things might be in extreme cases. It is no coincidence that the 75% probability of achieving coverage ratio is 1.00 because the income level of £6,977 was calculated specifically so that it was achievable with 75% likelihood.

The mean shortfall amount focuses on the scenarios where the desired income is not achieved and calculates the average monetary value by which the fund value falls short in covering the desired retirement income. For John this means that if markets perform worse than expected and he finds that his pot isn’t able to provide him with the income he needs, then on average he would need to top up his retirement fund by £39,965 (perhaps via alternative savings, or through equity release on his home).

What do these numbers mean for John?

So, let’s assume that John decides to withdraw the recommended annual income. This means he will receive £6,977 per year, increasing in line with CPI, for 14 years, at which point he will purchase an annuity. There is a 75% chance that the income he will receive from that annuity will exceed £8,877 and a 25% chance it will exceed £18,817. This provides John with an idea of the level income he can expect when he purchases his annuity.

In addition to the level of income he can expect, he can be 95% sure that his income will be no lower than £4,884p.a. and there is a 5% chance that his income could increase to more than £27,559p.a. This range gives John an indication of ‘how bad’ and ‘how good’ things could be and provide reassurance that the worst 5% of circumstances should still provide him with an income of £4,884p.a.

Finally, if markets perform worse than expected then, in order to achieve his target income level, John may need to top up his fund by, on average, £39,965. This is a useful reference for John who, over the next few years, should continue to monitor the value of his fund and should financial markets perform poorly then an additional savings pot of £39,965 should be sufficient to keep him on track with his target retirement income.

For providers, this is one example of how projections can be used as part of an engagement and decision making customer journey for people at and in retirement.