Shock Proofing Your Retirement Plans

Here are some positive steps you can take to defend against future shocks to your retirement plans.

In summer 2007, I found that the vast majority of us don't need to save anything like as much as the industry claims we do in order to have a comfortable retirement. I wrote a four-step guide that helps you to estimate how much you actually need to save each month.

However, there are various potential risks to your income when you retire. Hence, I'm writing a second pensions series, of which this article is the third and final part. In part two, The Many Risks To Your Retirement Plans, I explained what some of the risks are.

The industry's solution to reduce these risks is for you to give them every spare penny you earn for 40 years and hope for the best. Now I'm going to tell you how you can reduce the risks without throwing money at the problem mindlessly. By the end of this article, most people who use my four-step guide will see that, with a little shock proofing, they still don't need to contribute anything like the amounts the industry would recommend.

The state pension

It is the opinion of many Fool readers that you should not rely on getting any state pension at all and make adequate retirement provision entirely by yourself. My own view is that we're likely to get something, but it's already a small amount and it could be less still.

I think an adequate hedged bet, for those of us some way off retirement, is to halve what the government is currently telling us we'll receive from the state, and to plan our private retirement-savings arrangements accordingly. (My Four-Step Guide excludes completely the State Pension and relevant benefits, so the results you get are already as conservative as many Fool readers would like. If you want to add half the State Pension to your plans, read the fourth part of the guide.)

Defined-contribution pensions

I'll focus on defined-contribution pensions rather than defined-benefit pensions because, as I explained in part two, the risks to the latter are contained by an adequate compensation scheme. (However, concerned members of defined-benefit schemes can still invest extra money elsewhere.)

A defined-contribution pension is one where your contributions are invested, typically in the stock market. You'll still have your money if the fund provider collapses, but there are many more potential risks as I noted in part two - for example, an increase in taxes. Are all these things likely to happen at once? Of course not. But several things could go wrong for you simultaneously. We need to consider which ones to plan for in advance, and what that extra cost should be.

The first step is to consider alternatives to pensions, e.g. ISAs. Pensions are more risky than ISAs, because your money is locked in for a long time. There's not much you can do if the government does something unpleasant to pensions (again) once your money is already in the pot.

Even so, there are benefits to saving in pensions. Simple pensions are good for people who otherwise wouldn't know what to do with their money, or who would be tempted to spend the money if it wasn't locked up. It also makes sense to use pensions if your employer contributes to it: if an employer is doubling your contributions, this easily pays for the most plausible risks, and then some.

Planning for risks isn't totally free

If you stick with pensions your risk is higher but, regardless of how you invest for the future, things can always go wrong. We need to budget for that, and save a little extra. That extra depends on your attitude to risk. You need to think hypothetically...

Most of my investments are currently in pensions. I think that maybe my tax rate as a pensioner will be 10% higher. Maybe my investments will have underperformed by 5%. Maybe a couple of other small things will have gone wrong. Therefore I think that, to feel safe, I'm going to work on building myself a safety net by adding 20% to my monthly contributions. In the example I used in my Four-Step Guide, I was paying £184pm, so that means I must now pay £221pm.

Yes, that wasn't the work of genius. I've made no fancy calculations or studies of macroeconomic factors in order to assess these risks. Forecasters can't predict what'll happen next week, so how can any of us predict what'll happen in 10, 20 or 40 years? It is just the safety margin that I'm comfortable with. Your decision will depend on your own feelings towards each of the risks I've mentioned, and towards all other risks as well.

A collapse in annuity rates

Apart from contributing yet more to prepare for the possibility of annuity rates tumbling further, you have a few possibilities to consider.

It's likely that annuity rates, if they deteriorate, will do so slowly. This gives you time to make changes to your plan. Simply assessing rates every year and making small adjustments could be all you need to do.

My Four-Step Guide suggests that you track annuity rates every year and make adjustments to your monthly retirement contributions. However, it could be that annuity rates will rise before they fall. You could decide now never to adjust your monthly contributions downwards below what you're already contributing, even if annuity rates temporarily go up. This way, the falls won't hit you so hard.

You could continue to invest after you retire in order to hang on for better returns.

Finally, if the rates don't suit you when you come to retire, you can consider alternatives to annuities, like many other Fools do. Who knows what'll be available to you in all those years!

A late collapse in the stock market

If the stock market (or whichever market you invest in) collapses just short years before you retire, your plans could be destroyed. You can work longer or continue to invest after you retire, or you can take the hit and live on less than you wanted. It's better to try to avoid this situation.

My Four-Step Guide already suggests that you plan to have the retirement pot you need five years ahead of schedule. This gives you some breathing room. To increase your safety, you could use the industry's solution, lifestyling, or you can use my own preferred method, which is get the hell out of the stock market and other risky investments as soon as your pot is big enough. You can read more here.

Is the risk really all that great for the majority of us?

There are a lot of things that potentially could go seriously wrong, but I believe the risk is smaller than many others do, provided we plan properly. The great bit after completing this exercise is that most of you will still find you need to contribute a lot less than the industry would recommend, even though you're now playing it safer.