The timing of your retirement is important
Timing your retirement right can sometimes make quite a difference.
When it is only a matter of perhaps some months the overall impact is normally relatively small but issues such as the beginning of a new tax year (with new personal allowances), beginning and ends of Pension Input Periods (PIPs) and other time-related matters nevertheless deserve to be taken into account.
When delaying your final retirement date by a longer period of time (e.g. years) it may have a greater impact.
On the face of things it would perhaps seem quite trivial to calculate the effect of delaying retirement by a few years.
However, in practise, these calculations can be quite complicated and may include many factors and interactions between them.
Just to give a few examples: maintaining your earned income for longer not only gives you extra cash in hand here and now but also means that you will not need to touch our pension pot which will allow it to grow or longer.
Delaying retirement will also in all probability mean that your other pension entitlements will increase – and obviously the time spent in full retirement will become shorter (which means more money on an annual basis). By delaying claiming your State Pension you will also increase your entitlement for the rest of your life.
In order to account for all these variables and their respective interactions NFA use so-called computer simulation models and optimisation engines to identify the most advantageous retirement date given your personal circumstances,
It is not the intention to give you a detailed lecture here on how such simulations are carried out but to put it simply: all the different relevant parameters are expressed as equations and the combined effect of all these equations are calculated for various time periods.
It is important to note that there always are some uncertainty when such models are used as assumption have to be made regarding e.g. inflation rates, possible escalation of the State Pension, other pension payments etc.
Remember, no model can be better than the data used to construct it!
The figure below shows a very simplified output for a hypothetical client containing only a few variables. In real life such models will often contain 10-20 or more variables.
Using simulations (or Cash Flow modelling as it can also be called) in this way can give a reasonable overall idea of the extra funds need to fill a potential gap.
However, there is a problem when such a gap is to be filled either in full, or in part, by e.g. investments as they are far less predictable than e.g. the escalation of the State Pension etc,
Just making the simple assumption (as many ‘forecasters’ indeed do!) that investments will follow a historical norm and grow on average by say, 4-5% per year, over the next 20-30 years, can lead to very serious miscalculations.
Whilst the assumption of an average growth at this rate may hold true over longer periods of time it does not help you much if you incur serious losses already in the first 3-5 years of your retirement period. In this case there will be an awful lot of ‘catching up’ to do, and you may not have the necessary time!
In order to make some rational sense out of such uncertainties, NFA employs what is technically called: Monte Carlo Simulations.
The mere name may make you apprehensive but you can rest assured that it has nothing to do with gambling your pension pot on the roulette!
Monte Carlo Simulations (MCS) are basically used to answer the question of ‘what might happen’ if a lot of random events all turn against me time and time again – or, what is the worst case scenario.
Technically speaking, a MCS will use all the relevant parameters related to your situation and simply calculate the end result for a given date in the future (e.g. in 30 years time) assuming that everything goes as planned.
Once one calculation has been made, the process will be repeated, but this time one parameter will be changed at random (positive, negative or unchanged) and the result computed. Then, this result will be recalculated on the basis of a random change in another of the parameters – and so on…
Once 10,000 or more scenarios have been calculated a pattern starts to emerge.
The key feature that is of most interest to NFA is the size of the column to the very left in the illustration – as this is an indicator of the risk there is to run out of money.
As it can be seen from the example given above, in this case there is less than a 5% risk that the client’s pension pot will fall below £26,000 after 30 years even if everything that can go wrong does go wrong!
It is of course not much fun if the worst does happen – but given the rather low risk of this and the fact that there are 30 years in which action can be taken to mitigate this event the illustrated plan can only be described as quite robust!
It is the hope that the information on this page has shown you that by using a number of modern computer-simulation techniques, NFA can help you to obtain a quite accurate picture, not only about your immediate short-term financial situation but also about your likely future situation,
No computer model can predict the future but at least they can provide a foundation upon which sensible and informed decisions can be made.