Rethinking retirement

When the State Pension was introduced in 1908, the average life expectancy for women was 9.3 years beyond age 70, and 8.4 years for men – meaning that pensions needed to last around nine years.¹ In contrast, retirement today lasts an average of 20 years, meaning pensions must stretch much further.²

There is also growing inequality in life expectancies between the wealthiest and the poorest. Recent data from the Office for National Statistics (ONS) shows males in the least deprived areas of England live almost a decade longer than those in the most deprived regions, and females eight years.³

On the one hand, increased longevity is a cause for celebration. Residents of the Greek island of Ikaria – where one in three people live beyond 90 – have long been studied to uncover the secrets to a longer life. On the other hand, it introduces significant financial risk. Planning for a retirement income without knowing how long it needs to last can be daunting. Moreover, while life expectancy is rising, the number of years spent in good health has not increased proportionately. ONS figures show males can expect to spend 20 per cent of their lives in poor health and females 23 per cent – raising difficult questions about the cost and duration of care in later life.

Costs are already escalating. According to Which?, care home fees rose by 19 per cent in 2022-2023, driven by increasing energy and staffing costs.⁴ Retaining staff is also becoming more difficult, with many leaving for more appealing jobs in retail or hospitality. These issues, combined with the rise in interest rates for care homes with mortgages, are pushing providers to pass higher costs onto residents.

Retirement is evolving, largely because the combination of longer life expectancies and rising living costs is leading many to extend their working lives. The rate of economic inactivity among people aged 65-69 has fallen, from 90 per cent in 1984 to 73 per cent in 2023. During the same period, the proportion of inactive men aged 65-69 dropped from 86 per cent to 68 per cent, while for women, it declined from 93 to 77 (see Figure 1).

Volatile markets have also contributed to fears about whether savings will last through retirement. The traditional approach of saving and then drawing down a steady income may need rethinking, as more retirees opt for part-time work or re-enter the workforce. The rise in remote working, accelerated by the pandemic, has also enabled older workers to remain employed for longer.⁶ Beyond the financial benefits, extending people’s working life can positively impact their wellbeing by providing a sense of purpose and social connection (see Figure 2).

In 2021, Aviva’s Age of Ambiguity study revealed that over 40 per cent of people aged 55-64 plan to enter ‘semi-retirement’ before turning 65, allowing them to access pension savings while continuing part-time work.⁸

As our approach to retirement becomes more personalised, planning for it financially grows more complex. Strong client relationships built on trust become especially valuable as income needs vary throughout retirement. By maintaining these connections and regularly reviewing and adapting investment plans, advisers can help ensure flexibility and responsiveness to changing circumstances.

Longer life expectancy is now one of the most talked-about challenges retirees face. As some opt for a gradual transition into retirement and explore a broader range of investment options, more people are staying invested during retirement, withdrawing income only as needed. The old approach of fully de-risking at retirement and choosing a fixed income for life is no longer the default. However, embracing the flexibility of drawdown does not eliminate the need for income security.

A well-designed decumulation strategy considers the specific risks and uncertainties of retirement as part of its design. With an average retirement lasting 20 years, retirees often do not need access to a large portion of their savings in the early days. Recognising this allows them to stay invested and potentially benefit from greater returns. While past performance does not guarantee future results, holding more volatile assets like equities may help achieve better long-term returns, as historically, equities have outperformed lower-volatility assets like fixed income over long periods.

Another risk faced in decumulation is sequencing risk. Two portfolios with the same risk profile, asset allocation and expected risk/return can yield quite different outcomes depending on the sequence of returns when withdrawals are being made.

During the accumulation phase, when saving for retirement, the sequence of returns is irrelevant. This can be demonstrated by looking at a 20-year period for the S&P 500, from 1999 to 2019. If no withdrawal were needed, an investor would have been indifferent between holding the more volatile S&P 500 or receiving a steady 6 per cent annual return (see accumulation phase in Figure 3).

However, once income withdrawals begin, the sequence of returns becomes crucial. In a falling market, the retiree will need to cash in larger amounts of their pension fund to maintain a regular income. This can deplete the fund faster. The impact is particularly severe when it occurs in the early years due to the compounding effect. Poor early returns may cause a portfolio to ‘lock in’ losses and could result in ‘pound cost ravaging’ (see decumulation phase in Figure 3).

In the UK, pensions remain a cornerstone of retirement savings, thanks to tax relief and employer contributions. However, the burden of saving is shifting from employers to savers, with companies moving away from defined benefit (DB) schemes. Since 2012, memberships in defined contribution (DC) and hybrid schemes have surged, from two million to 28 million, thanks to auto-enrolment laws.¹¹ These reforms have boosted pension savings, with the share of eligible workers saving in pensions rising from 44 per cent in 2012 to 86 per cent in 2020.¹² Recent changes have extended auto-enrolments to workers aged 18 and above, and allow saving to start from the first £1 of earnings, helping groups like women and carers who were previously excluded.¹³

Despite these improvements, most private-sector workers still save less than eight per cent of their income – well below the 15 per cent recommended by Lord Turner’s Pensions Commission.¹⁴

The 2015 pension reforms, which allowed savers to access their DC pension from age 55 under new pensions flexibility rules, led to a decline in annuities and an increase in people opting for drawdowns or lump sums. However, with volatile markets and rising inflation, there is now a greater risk for pensioners of running out of savings – putting retirement planning under the regulatory spotlight.

The FCA’s Consumer Duty regulation, introduced in July, marked a shift in regulatory requirements. Advisers are now expected to deliver good outcomes for clients throughout the retirement journey, not just at the point of sale. This has a “cross-cutting” relevance to the advisory process during decumulation. It introduces expectations related to product functionality, pricing, and a consumer’s understanding of what they are buying.

The FCA’s thematic review, outcomes from which were published in the spring of 2024, provides a first deep dive into the retirement advice process since pension freedoms were introduced, and serves as a benchmark for how well advisers are implementing consumer duty.

One of the key findings of the review was the importance of accurate and consistent record-keeping. There were significant differences between firms in how well they documented advice, and not all firms accounted for the varying needs of clients in the decumulation phase. While some firms considered the needs of vulnerable customers, many failed to implement processes in an effective manner.

Alongside the review, the FCA raised concerns around the use of cashflow modelling, particularly the realism of assumptions and whether clients truly understood the results. The FCA’s findings came with a letter to the CEOs of advice firms, urging them to take immediate steps to address these issues. The message is clear: delivering good client outcomes requires a centralised retirement proposition, one that recognises the strategies used for accumulation aren’t always suitable for clients in decumulation.

The rise of behavioural finance has shown we are not always as rational as traditional economic theories suggest. Our brains are wired for survival, and we use mental shortcuts – heuristics – to make things more manageable. However, these shortcuts can be influenced by emotions, making them less reliable in the early stages of this new phase of life. This is best captured by Carl Richards’ concept of the ‘Behaviour Gap’, which illustrates the difference between the theoretical return on an investment when decisions are made rationally, and the real returns people make when emotions get involved.¹⁵

This is relevant because retirement means withdrawing an income rather than earning one, marking a significant psychological shift. For many, work provides purpose, social interaction and a sense of identity. Losing this structure can be emotionally challenging.

As we retire, the world looks different, and adapting to this new reality takes time. Cognitive biases do not disappear in retirement – in fact, they may become more pronounced.

Recognising this shift in clients is essential to understand any behavioural changes they may exhibit. Understanding a few of the most influential biases, and how they affect clients in retirement, can help with the advice process in decumulation. The FCA’s Consumer Duty guidelines emphasise that consumer decision-making can be impaired by factors like limited understanding, information asymmetry and behavioural biases, so an appreciation of the potential of these factors to muddy the water is useful.¹⁶

Anchoring

The origins of our wealth often impact how we use it. Most people assume that, once the kids have left home, they will downsize and free up capital to enjoy life. However, the emotional attachment to a home is underestimated. Behavioural coaching can help with this.

By acknowledging that selling the family home is not straightforward and in fostering a more open dialogue about their reservations, advisers are more likely to engage their clients meaningfully, deepening the relationship.

Risk aversion

As we age, we generally become more risk-averse. Research from New York University suggests a biological bias for this – a decrease in grey matter that correlates with greater risk aversion.¹⁷ While a client’s risk appetite will be the result of a number of factors, this change, which happens to varying extents to everyone, acts as a reminder of how important it is to develop strategies that help clients manage levels of risk that are appropriate for them.

When clients start spending their savings, new uncertainties can trigger a strong urge to protect their assets at all costs. Even those who once understood long-term investing may become reluctant to take risks, especially if they believe they no longer have time to recover from a market downturn. However, with people living longer, being overly cautious can increase the risk of depleting their savings too soon. Advisers can help by addressing key questions: Is there a mismatch between the client’s goals and their current investment strategy? What is their time horizon? How much of their portfolio will they realistically need in the next decade? Using data and clear illustrations of potential outcomes can help clients recalibrate their risk tolerance to better align with their goals.

Confirmation bias

Humans tend to focus on information that reinforces what they already believe, and this can be particularly problematic in retirement. In an era where we can curate the news and information we consume, it is easy to avoid viewpoints that challenge our beliefs. This bias can become even stronger as people age, making it difficult for clients to consider new or unfamiliar investment strategies, even when these might yield better outcomes.

Advisers can play a key role by introducing alternative strategies and providing clear, evidence-based explanations. This approach can help clients manage their wealth in retirement with a more open and rational mindset.

One of the key areas of focus in the FCA’s thematic review is how well the retirement income advice market is functioning, especially as consumer needs are evolving due to rising living costs. With retirement potentially spanning decades and transitions into this phase becoming more varied and staggered, predicting precise income needs can be challenging. 

The traditional “four per cent rule” for retirement income planning was once widely accepted. It suggested clients could withdraw four per cent of their portfolio in the first year of retirement, then the same (adjusted for inflation) each year thereafter, with the expectation that their savings would last throughout retirement. However, this approach relies on broad assumptions about inflation, life-expectancy, and lifestyle needs – assumptions that may no longer hold true under the realities we discussed earlier.

An alternative approach is to categorise a client’s financial goals based on their importance and plan how to meet these income needs accordingly. Wade Pfau’s “4Ls pyramid” is an approach that can help advisers assess how much risk a client can afford when planning for retirement. This framework guides whether to adopt a safety-first or a probability-based approach to investing (see Figure 4).

Figure 4: The 4 Ls of retirement income planning

Source: Aviva Investors, Wade Pfau, October 2024.¹⁸

The pyramid is broken down into four layers (bottom to top): Longevity, which covers must-have expenses like housing and healthcare; lifestyle, for the fun stuff like travel and hobbies; liquidity, making sure clients have cash on hand for emergencies; and legacy, which is the money they want to leave their loved ones or donate.

It might seem that income needs become less essential as we move up the pyramid. However, more people want to enjoy a comfortable retirement, meaning the ‘liquidity’ layer may be less optional than expected. Visualising these different financial buckets during client discussions can provide structure, leading to more thoughtful and effective outcomes.

Retirement planning has become increasingly complex as life expectancies rise, costs grow and regulatory landscapes shift. The traditional one-size-fits-all approach no longer applies, and financial advisers must rethink their strategies to meet the varied needs of modern retirees. From managing the risks of decumulation and navigating volatile markets, to understanding the psychological challenges clients face in transitioning from saving to spending, advisers play a critical role in securing their clients’ financial futures. By staying flexible, informed, and customer-focused, advisers can help their clients adapt to the uncertainties of this new retirement era and ensure they thrive in their later years.