Sometimes emotions drive client decisions so advisers need solutions that satisfy emotional and financial objectives.
As humans, we have very elaborate neural systems to address threats. In particular, the emotional circuitry that kicks in to protect us from perceived threats – the ‘fight-or-flight’ response.
But there is a very important distinction between threats in the modern world versus threats on the plains of the African savanna a gazillion years ago. Unfortunately, when we are faced with threats from the modern world, such as financial threats, that same circuitry kicks in — increased heart rate, blood pressure, and so forth.
While that response may be very helpful in protecting us from physical threats, it’s actually counterproductive in protecting us from other threats, which are much more subtle and require the use of different parts of the brain – parts that shut down in the face of extreme emotional stimulus.
For instance, ‘fighting or flighting’ are not the most appropriate – nor the most productive – responses to the inherent risk presented by the person in front of me at the cake counter in Betty’s ‘umming and erring’ over whether to snaffle the last of the miniature Fat Rascals. Fortunately, my resolve was not tested as said patron opted for the pistachio macaroon. Risk averted, more owing to good fortune than good planning – an approach ill-suited to retirement income portfolio construction.
Since the introduction of pension freedoms, people approaching retirement, their advisers and providers are considering the most effective and efficient ways to use the flexibilities while balancing the various risks that come with this freedom of choice. As such, professional advice will be key to making sure that people are able to meet their individual financial and (importantly) emotional retirement needs.
The focus of the previous regime was based around the management of longevity risk, through annuities or capped drawdown products. The removal of restrictions places more responsibility, and consequently more risk, on individuals.
In addition to the so-called ‘big four’ risks (longevity, inflation, flexibility, and volatility) individuals and their advisers will need to consider a number of other factors.
In particular, it is expected and acceptable that sometimes emotions will drive decisions. For example, not selling the family home to trade down to release equity, or taking lower-risk options even though they give lower returns because they provide peace of mind.
During decision making, clients have competing objectives. Any solution will therefore need to satisfy a blend of both pure financial and emotional objectives, requiring a far more subtle but dynamic approach to risk and retirement income planning.
Phil Wickenden is managing director at Cicero Research