Some financial experts like to describe the financial planning exercise, when measured over a lifetime, as being akin to filling up a bucket and then slowly emptying it.
This is probably a clunky metaphor, with many holes in its accuracy of the actual effect (few people want to empty their bucket entirely for example) but it tends to work to create the right thinking and understanding to the accumulation/decumulation effect.
The basics are this: for a good part of your life your incentive is to accumulate (savings and wealth) and then at some point, you ‘cash in’ and start to use these accumulated sums to pay for your latter years.
Therefore, you de-accumulate. “Decumulate”.
On the surface this may seem simple.
As you might imagine that decumulating is a broad brush exercise where you simply dip into your savings.
The reality however is somewhat different.
The complications with decumulationThere are numerous reasons why decumulating starts to become more complex:
- You might not be able to easily spot the moment when you shift (or will shift, in the future) from accumulating to decumulating.
- And/or this may not be something you control (redundancy etc.)
You have no idea of your future lifespan, nor your health span, therefore you can’t know what your lifetime expenditure will look like. Or how long it will need to last.
Many people want to maintain their wealth, or at least a substantial part of it, as a legacy.
Future inflation and interest rates are unknowable.
As are investment returns and asset performance.
Taxation and government policy may radically change.
There could be other factors, dependent on your circumstances, but the list above is enough to start hinting at the complexities.
The biggest single aspect and, as a consequence, the biggest difference to accumulating is what we would describe as the ’elastic’ within your planning.
This is a crucial point.
The elastic aspect
As an accumulator you enjoy significant elasticity in your ability to accumulate successfully.
- If something shifts in your life, you can shift with it.
- If you lose your job, you can stop saving for a while, and find another job.
- If you are in business and it fails, you can start another business.
- If you die, and you have your finances well sorted, your beneficiaries can receive an equivalent value of your future accumulated sums as a life assurance pay-out.
Likewise, if you suffer a critical illness, and you are properly insured, you can receive a lump-sum pay-out. You can use insurance to buttress your plans and you have flexibility in recovering from setbacks.
You can have a bad run with your investments (they return little or lose money) and you can pick this up through a later period when things get better.
You can decide to put off retirement for a few years if you are short of your targets, and accumulate for a little while longer.
There is a lot of elasticity.
When you start to decumulate the elastic starts to shorten or get taut.
For example, if you have retired and rely on your accumulated sums to help pay for your expenditure in retirement, do you have enough to pay the bills for care if you or your partner suffer from dementia?
There is limited elasticity, if this happens to you or your partner, you can hardly decide to go back to work. You will struggle to find conventional insurance solutions to pay-out.
Or, if you are leaning on investments to produce income and you suffer some difficult years – because the investments perform badly – have you got the time and the ability to hold off waiting for a turnaround?
The answer may well be no, due to the problems with ‘sequence of returns’ risk, which is uniquely a risk faced by people taking withdrawals from their savings or investments.
You may not have the elasticity in your plans to cope with anything other than Plan A working.
What about inflation?
And by inflation we mean the costs of the things you buy and spend money on, not the official inflation rate.
If inflation is high, say 3% per year for the next 30 years and you live for that period, you will need to have roughly a third more income in ten years than today to pay for the same basket of goods.
Remember, we have never seen a sustained high inflation period and modern retirement trends at the same time.
The point is, once you start decumulating or requiring your previously accumulated sums and wealth, in some way, to prop up your income and lifestyle, the elasticity – the options you have to change course – are very different and, typically, limited.
The lack of flexibility means decumulation should be pursued with a different strategic approach
It is a gross over simplification, but suffice to say a typical accumulation strategy can have an aggressive approach to it, save and invest using real assets with insurance built in to cope with setbacks and the unexpected.
The accumulator knows they have plenty of options to change course or recover. Things like “certainty” and “guarantees” “safety” and “underpins” have completely different values applied to them.
For the decumalator, who has less elasticity, the value of those things can be very high.
So, the value equation changes. As does the risk management.
We discuss the way to look at guarantees and certainty elsewhere (click here) – the important part of this, in context of this article, is that your decumulation approach needs to understand how the value equation changes, how the risk management needs change and how your financial planning adjusts accordingly.
How to assess the value equation
The trick is to take a proxy view.
Instead of trying to measure everything in precise value terms, you can use software to assess your decumulation options. The software, cash flow and expenditure forecasting software, will draw out the value position by proxy.
In other words, used well, it will become clear when you study variable pathways of possible future scenarios where the value lies.
It will, as a by-product, also indicate how to risk manage your position.
These combined elements will inform your planning like nothing else can or will.
Cash flow forecasting enables you to plot all those scenarios where you are at risk and you can see what happens.
You can, for example, set your typical expenditure at £25,000 per year and run that through to your age 100 and see where that leaves you.
Now run it through at 3% inflation, what does that do to your income and savings?
Now, run it through for 10 years at £25,000 per year and then increase it to £75,000 per year for the next 20 years.
Why would you do this? Because you may need to pay for care.
If you are relying on investment income to support your retirement expenditure, what happens if that invested money falls by 10% per year for each of the next three years?
What happens if one of your kids suddenly needs £50k to help them out of a hole?
Using future cash flow forecasting software is really a necessity if you are serious about financial planning successfully, because it tests future scenarios against your current position and plans.
And when it flashes red, for example because it starts to show either more expenditure than income or, even worse, that you will run out of money, you can adjust your plans today and see what difference varying your approach takes.
This could lead for example to seeing that the value of £50,000 in Premium Bonds is way less to your future financial wellbeing than swapping this for a lifetime guaranteed income, say from an annuity.
It could tell you that the value of taking risk with investments is no longer as high to you as playing it safe and preserving what you have.
Or it could tell you the opposite.