The camera lens opened and shut in his mind as he saw himself driving a convertible down an ocean highway. Along the bay shoreline, a windsurfer toyed with the breeze; he pulled into a marina café that unfolded onto the sands …
The road to retirement is indeed paved with good intentions; however, your retirement strategy may be hampered along the way by stock-market volatility, fluctuating interest rates, and inflation. It is important therefore to connect the dots in order not to be thrown off course in your planning. The life-cycle hypothesis With many people living for up to 30 years in retirement, the onus is shifting to the individual to take responsibility for their pension planning. The situation can be analyzed in terms of savings and consumption over the life cycle. The concept of the life-cycle hypothesis was first developed in 1963 by Franco Modigliani (see chart below). The life-cycle hypothesis assumes that individuals consume a constant percentage of the present value of their life income; the level of consumption is dictated by preferences, tastes, and income. Modigliani argued that the average propensity to consume is higher in young and old households, where members are either borrowing against future income or running down life savings. In contrast, middle-aged people tend to have higher incomes with lower propensities to consume and higher propensities to save. The development of both occupational and private pension schemes targeting the middle-age section of society has been a welcome savings model to help provide an adequate income level after retirement. Life-cycle hypothesis
Source: Modigliani (1963)
Using the pension life-cycle process as a retirement strategy
Pension advisors conduct both a client profile and a risk profile of the investor in order to have a careful evaluation of retirement income needs and ascertain the type of investment approach to be adopted. At this stage, the individual is informed of the risks associated with each investment choice. Information is also collected on the desired level of pension income upon retirement and the level of contributions to the scheme. Thereafter a strategy is designed for each individual in line with their goals and objectives; this in effect is the role of management. The aim is to have the correct balance in terms of risk and return as the individual progresses through life; this balance can be adapted as circumstances change. Whether the individual is a member of a company pension scheme or invests with the help of a financial adviser, there is a need for a structure that limits risk when approaching retirement. Although there is no set timeline for the rebalancing process, research has found that the most rewarding life-cycle strategies are those that maintain a constant exposure to equities during most of the pension fund accumulation period, whilst gradually moving into fixed income-based investments in the last decade before retirement. Pension modelling is used to simplify complex issues and explore the likelihood of different scenarios occurring. When using pension modelling, there is no ‘one-size-fits-all’ retirement strategy, but moreover a range of outcomes for each approach taken. These outcomes will differ as conditions in the marketplace change. Through the aid of technology and the development of suitable default options, pension fund managers will seek to design life-cycle savings models that deliver optimal investment strategies geared to retirement. Pension models that calculate the projected return on investments allow individuals to estimate the value of their savings over the period. However, having faith in fancifully high returns often results in many people saving too little and being forced to recalculate their retirement plans at a later date. To experiment with how much you need to retire, try out our pension calculator. The journey to the promised land of retirement has many twists and turns. Upon arrival, the reality of the situation may differ from the earlier vision of how it would be. Perhaps it is best to be a little more cautious in terms of your retirement strategy. Indeed, the house with a sea view may have to wait!