Balancing retirement risks - pre-retirement (part 1)

A successful financial life will often come with the need to balance the choices that arise at various stages during our lives.

We might forego a holiday one year in order to save extra for the wedding of our dreams the following year or maybe slow down the savings and investments when childcare becomes more important.

The journey both before and after retirement is no different, with financial and emotional factors pulling us towards one option or another along the way. It’s a balancing act!

In part 1 we’re going to look at pre-retirement risks that we need to balance.

PRE-RETIREMENT

During our working life we’ll want to strike the right balance between spending our hard earned cash on enjoying life today, because let’s be honest, no-one is guaranteed tomorrow, whilst putting some aside for our future selves, so that we can quit the 9-5 and enjoy life on our terms and with all the freedom and choice that retirement provides.

But what do we do with the money for our future?

If we exclude property, as it’s not really passive income, then we are basically left with either saving it or investing it, so let’s look at those in more detail and see what risks are involved.

Saving

A large percentage of us in the UK do not have enough savings to cover a £1,000 emergency, so if you’re in the minority of regular savers, then give yourselves a well earned pat on the back!

Often we choose to save our money into a cash ISA or high interest savings account as this is often seen as the ‘safe’ option, which it is. A guaranteed interest % each year depending on what the bank is offering at the time, sounds like a sweet deal right?

Well, it depends…

The interest % paid out by banks is often similar to the rate of inflation and therefore our ‘real’ return is likely to be very small. For example, we might get 4% interest but everything we need to buy has increased in price by 3%, so our ‘real’ return is 1%.

This becomes a much bigger problem over the longer term because while we’re dutifully tucking away some of our wages each payday, the reality is that inflation is eroding the value of those savings over time.

Let’s say we have worked out that we will need £500,000 (in today’s money) for us to be able to retire comfortably when we turn 60. We have just turned 40 and have been saving money for the past 15 years and amassed £50,000, awesome job!

However, if we continue down this path, in 20 years time when we reach 60, we will have around £170,000 (in today’s money) in savings at 1% real return (4% interest less 3% for inflation).

This is the major RISK of ‘saving’ for retirement rather than ‘investing’ for it. We think we’re doing the right thing, saving our money, not taking any risks that might jeopardise our future, but in doing so, we’re unlikely to have enough saved for our dream retirement.

In this example, we’re a massive £330,000 short of our target. Not great, so what can we do about it?

We have to get our money working harder for us and it has to outpace inflation in order to grow our ‘real’ wealth in the future. We have to be willing to take some other perceived risks and to start investing our money.

Sounds scary, but it really isn’t when you understand how it works.

Investing

The first thing to say is that a lot of people are already investing without them actually realising it. If you’re employed and pay into your company pension scheme then you are in fact an investor, congratulations!

Probably the biggest barrier for most of us to start investing for ourselves is the risk of losing our money. Us humans have a much stronger emotional reaction towards losing money than we do towards the chance of gaining money. It’s called loss aversion.

We also need to understand that when we hear the word ‘investing’, most people have some preconceived ideas about what that means.

• “That’s only for rich people”

• “That’s only for smart people”

• “I don’t have time to buy and sell shares all day”

• “What do I know about valuing companies”

These are either not true or describing ‘Day Trading’, which is completely different to the investing that we are talking about here. This is putting money into a Global Index Fund, which is just a fund of lots of different companies from around the world.

It means we don’t have to pick a company, sector or country to invest in, the fund does it all for us. Once it’s set up, we can just automate it and get on with the rest of our lives!

If you’ve been a saver up until now then great, that mentality will be perfect for investing as well. Set aside an amount per month, every single month. It’s actually pretty boring, but that’s how it should be.

Now then, back to the RISK of ‘investing’. There is risk involved for sure, our investments will absolutely go up and down. This is called ‘volatility’, and it’s the stock markets moving in value every single trading day.

This is the risk of losing our money when investing in a global index fund over different time periods that you remain invested in. These are averages over the past 30 years.

• 1 day = 50% (basically a coin flip as to whether we gain or lose money each day)

• 1 month = 40% (slightly better but still not great odds)

• 1 year = 25% (1 year in 4 has lost money)

• 3 years = 15% (we now have an 85% chance of gaining money over this period)

• 5 years = 10% (this is often cited as the minimum time horizon for investing)

• 10 years = 5% (the longer we hold the investment, the better the odds)

• 10+ years = 0% (long term investors in global index funds have not lost money)

So we can see that staying invested for a long period of time is the key thing here, certainly over 5 years but even better to be over 10 years, and because we’re taking investment risk here we should expect to get a greater return on our money right!

Absolutely, the average return of global index funds over the past 30 years is around 10%, so if we take off 3% inflation as we did with savings, then our average ‘real return’ is 7%. We won’t get this every year of course, some years it may go up 20%, then down 5%, but on average over a longer period of time it has achieved this.

So what does this do to our previous example where we have £50,000 and 20 years of investing left, well let’s take a look!

£50,000 invested in a global index fund at 7% real return (10% average return less 3% for inflation) gets us to around £330,000 in 20 years time.

Ok, so it’s still £170,000 short of our £500,000 target, but it’s also £160,000 more than with saving alone and we’re much closer to our target.

This offers us the opportunity to TAKE ACTION now to close the gap, at 40, whilst we still can, whilst we’re still in our prime earning years. 

Summary

So at first glance, investing may seem to be the more risky option, but when it comes to building our retirement pot, hopefully we can now see that saving is actually the bigger risk.

However, they both definitely have their place. If we need access to our money within the next 5 years, for an emergency fund or house deposit, etc, then SAVINGS are definitely the right place for this part of our money.

For money that we can lock away for more than 5 years, which is often for our retirement, then INVESTING it is likely the best option for us.

It’s all about finding the right balance!