Calculating how much money will be needed to last through what we all hope will be a peaceful and lengthy retirement can be a daunting, time-consuming task. Some folks see it as an unmitigated chore; others tackle this self-imposed, arithmetic project with admirable vigour.
However, when constructing what can be anything from an objective, well-considered retirement plan to wild calculations which, at their core, appear heavily reliant upon winning the Lottery, most of us overlook the almost equally important ‘lifestyle’ element.
‘Lifestyle’ is a word which, if you asked 50 people to define, could yield 50 different answers; that we must consider it at all confirms that retirement planning is not all about money. A multitude of factors, such as taking a reasonable stab at expected longevity; considering the chances of uprooting from a home where you’ve lived for donkeys’ years, or mulling over whether elderly parents will require increasing levels of care must also be taken into account.
In effect, money and lifestyle, ie how would you prefer to live your life, and pay for it, post full-time employment, confirms that the two are inextricably linked.
Whatever our lifestyle definition, it’s a given that we must discover a way of paying for it, a potentially dangerous assignment into the world of finance where we’re likely to be confronted with a succession of different risks, some we can anticipate, while others are completely unexpected.
For the sake of example let’s say we use a percentage of our pension to invest in a legitimate, well-managed, solvent investment fund. It’s at this preliminary juncture that we face our initial, sobering, risk: namely, there is absolutely no guarantee that the fund will achieve its objective. As we’re frequently (and accurately) reminded, investors can lose some or all of the amount they invested.
Moreover, should our investment fund invest in assets denominated in, say, dollars or euros, (and either is perfectly probable) , the value of an investor’s stake may fluctuate in line with exchange rate movements, ie find itself exposed to currency risk.
Then there’s a real ‘left field’ risk. You see, some fund managers have a remit to use derivatives, either for investment purposes or, in some instances, for what is termed ‘Efficient Portfolio Management’. Using derivatives can be particularly risky – even negligible movements in the value of underlying investments can trigger an unexpectedly large movement in trading prices, hence ‘derivative risk’. To find out if a fund manager has a derivative remit, it’s essential for the investor to read through the fund’s longer-term objectives and how they may be achieved.
Usually, would-be investors will happen upon a lengthy list of further risks, including credit risk; interest rate risk; inflation; equity risk; liquidity risk; emerging market risk, or strategy risk.
Then, just when you thought investment couldn’t get any riskier, along comes ‘capital erosion risk’, a scenario in which the fund managers take their firm’s charges from the fund’s capital, a proportion of which will be taken from investors’ investment. This can happen periodically, usually when insufficient capital growth has been generated by the fund to cover its charges. In turn, this can hit investors in the pocket, primarily because the impact of capital erosion reduces the investors level of dividend income.
Clearly, calculating the amount needed for retirement is an exercise littered with a series of risk-related considerations. Which brings us on to what can emerge as a welcoming level of certainty afforded by equity release.
There’s more to equity release than many people imagine. For eligible homeowners aged 55 and over, a drawdown lifetime mortgage can provide flexibility by allowing an initial release of funds, with the option to take further amounts later as needed rather than all at once. However, any future drawdowns remain subject to the lender’s terms, conditions and product rules, and are not guaranteed.
A drawdown lifetime mortgage enables older homeowners to access a percentage of the bricks-and-mortar wealth built up in their home. Following an initial withdrawal of an agreed, tax-free sum, the homeowner can set aside the remaining balance, withdrawing it when required. In the example below, this is every year for a decade.
It’s worth noting that equity release drawdown offers homeowners the opportunity to enjoy a significant saving as interest is only charged on the funds once they’re withdrawn, not on the balance set aside as referred to above. In other words, withdrawing a series of smaller amounts according to the homeowners’ capital requirement plan (see below) can save the homeowner significant sums of money when compared to the interest charged on a larger, one-off lump sum.
Note, too, that all supplementary withdrawals remain tax-free and at the interest rate prevailing at the time – therefore, not all withdrawals will be at the same rate.
Furthermore, while withdrawing a significant lump sum can result in the loss of means-tested benefits such as Pension Credit or a reduction in council tax, the equity release drawdown option can, in many instances, ensure that the homeowner remains entitled to receive these benefits as she is withdrawing smaller amounts, thus keeping her under the means-tested threshold.
Consider the chart below, an example of how drawing down smaller sums of money every 12 months from what could be called the ‘equity release pot’, can shelter the homeowner from a succession of investment-related risks and instead leave them in complete control of their funds. For the sake of this example, I’ve made several assumptions.
- The homeowner(s) arrange to release £ 84,000 from their property – taking £10,000 for holidays and lifestyle costs, with the remaining £74,000 in a ‘drawdown’ facility.
- From the drawdown facility, they aim to pay themselves £7,200 a year over a 10-year period, adding an annual allowance for estimated inflation.
- In year 2, the chart shows that estimated yearly inflation rises by 3%. In addition to the homeowners’ ‘base’ income of £7,200, therefore, we can add a further £216 (3%). In year two, this amount is £222 and so on.
- By the end of year 10, the homeowners have withdrawn £73,964 of the £74,000 they had set up in their initial cash reserve facility. They have also assumed that inflation rises over the same period by 24% and sheltered the real value of their annual withdrawal by taking this into account.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| Inflation Estimate (%) | - | 3 | 3 | 2.5 | 2.5 | 2 | 2 | 2 | 2.5 | 2.5 |
| Inflation Sum (£) | - | 216 | 222 | 191 | 196 | 161 | 164 | 167 | 213 | 218 |
| Total Withdrawal | 7200 | 7416 | 7638 | 7829 | 8025 | 8186 | 8350 | 8517 | 8730 | 8948 |
The example above shows how equity released from the home can be used to supplement yearly finances, but homeowners may withdraw funds when ‘lifestyle’ determines the need for additional funds, including expenses such as medical care, home improvements etc without having to apply for a fresh loan each time funding is required.
As with ‘traditional’ equity release, homeowners selecting the drawdown option remain 100% legal owners of their property and continue to benefit from any future increases in its value.
Similarly, the ‘No negative equity’ guarantee, supported by the Equity Release Council (ERC), remains in place, provided homeowners conduct their equity release dealings through a firm registered by the ERC. Additionally, there are typically no mandatory monthly payments required, while many equity release plans enable homeowners to ‘ring-fence’ a percentage of their property's value for their children or other beneficiaries.
Financial planning, especially calculating how much money will be required to enjoy a healthy and lengthy retirement ‘lifestyle’, is a demanding exercise requiring our full attention. It follows that before making any long term decisions, older homeowners in particular should probably consider exploring the advantages and disadvantages of equity release.
