Danby Bloch: The hierarchy of retirement income needs

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Assessing a client’s capacity for loss in retirement is one of the most important, but also one of the trickiest, parts of the planning process for drawdown. With this in mind, it is welcome news when methods emerge to help advisers tackle the issue.

The process of assessing capacity for loss should be more about understanding the extent to which clients can cope with a major fall in their income than about the impact of capital fluctuations. The trouble is that most capacity for loss discussions are often more about falls in capital values than reductions to the client’s income.

The aim should be to assess clients’ income needs and to understand which of them are essential and need to be met under all circumstances. This can then be distinguished from the less essential income that the client could reduce or even dry up altogether without having a major impact on their core living standards. Some falls in income would be manageable; some would not. The key is to assess which is which. It is not rocket science.

This simple idea that should be at the heart of planning for expenditure in retirement has been systematised, first in the US by money guru Mitch Antony and then with some adaptations for the UK by Just Retirement.

The easiest way to envisage this set of priorities is as a pyramid (see image). The pyramid illustrates the various building blocks of retirement income needs.

pyramid

Immediate concerns and debt

At the very base of the pyramid are the client’s most fundamental needs: the immediate concerns and debt. Many clients of financial advisers do not have much in the way of high cost consumer debt but some will do. The top priority is usually to clear these. There is also usually a good case for paying off the mortgage, which is likely to cost more than most investments can yield on a post-tax, post-inflation basis.

Essential income

This is the basic income most people need to meet their day-to-day expenditure on the basic core needs of life. It includes such items as food, clothing, housing costs and running a car. If a client could not meet these expenses, they would have to make major adjustments to their finances, possibly involving moving house and trading down.

Just in case fund

Strictly speaking this contingency fund is a static balance sheet item rather than part of a client’s income and expenditure matter. However, it is necessary to provide for this in the planning process. A common view is that this “just in case” fund covers about six months’ essential income needs and it should normally be kept in cash or near cash.

Freedom income

Once the client has met their base-line needs, they can consider the “freedom” or discretionary expenditure. This is expenditure that could vary if necessary, even if the clients have become used to this kind of spending in the years up to their retirement. Of course, some people’s idea of essential spending corresponds to other people’s view of discretionary expenditure.

Gifts

With a comfortable amount of income available, clients may wish to help other members of their family, most likely younger relatives who need assistance with education costs, buying a home or setting up a business. Some clients may also wish to make significant charitable donations.

Dreams

At the top of the pyramid are the dream purchases and spending. These could be high cost holidays, special cars or works of art. Most people do not achieve this to any significant extent but some do.

These different priorities can then be incorporated into the client’s long-term cash flow modelling. Cash flow modelling is particularly useful when modelling different scenarios to show the impact of decisions clients might make. It can be used to illustrate scenarios of different income requirements depending on changing investment returns or other developments that might take a client down the expenditure pyramid (for example, if there is insufficient income for discretionary expenditure).

The combination of prioritising income needs in a way clients can understand and then using it in cash flow modelling can be really powerful.

Danby Bloch is chairman at Helm Godfrey