Creating a lifetime income - The 5 steps

Posted by Stephen Sutherland on Tue, Aug 07, 2012 @ 01:00 PM

Creating a lifetime income   5 stepsIn the third blog of this series we'll look at 5 steps you can follow to create a lifetime income.

In our first post we looked at how ever increasing life expectancies could see some people running out of capital in retirement, and in our last post we saw how investing in growth funds could offer a solution.

The 5 steps to creating a lifetime income

Let’s look at five steps to creating a lifetime income:

  1. Switch to long-term thinking
  2. Invest for growth
  3. Health and wellness
  4. Time and compound interest
  5. Smart income drawdown 

Switch to long-term thinking

Many unsuspecting investors make the fatal mistake when approaching retirement of failing to plan for a long enough time horizon. Volatility and sitting through market corrections may make the investor feel bad in the near term, but if they die before their spouse and fail to plan for the correct time horizon, they could be leaving their partner in aged poverty.

Invest for growth

If an investor who is approaching or in retirement extends their investment time horizon, they may then decide to take on additional risk by investing in more adventurous funds; funds that have the potential for attractive long-term returns. Smart investors use tax wrappers such as ISAs and SIPPs to further boost their returns and pay less tax. Outperforming the market over the long-term may be extremely difficult to achieve, however it is possible. When an investor is successful inbeating the market’, it helps them achieve higher returns and reduces the risk of running out of capital later in life.

Health and wellness

When an investor changes from short-term thinking to long-term thinking and decides that they are going to aim for growth by investing in growth oriented funds, another area to consider is their health and wellbeing. Scientists say that determinants of longevity are things such as country of residence, the health care system where you live, genetics, standard of living, healthy behaviour, education and environment.

Even though there are some things that are out of our control, such as our genetics, each of us has the power to choose – allowing us the potential to make better decisions relating to our health and wellbeing. Each of us can decide to take better care of ourselves by learning more about health and nutrition, eating the right foods, exercising regularly and appropriately resting. On the other hand, we can decide to stay ignorant about health and nutrition, eat the wrong foods, refrain from exercise and generally neglect our bodies. The choice is always our own. One course of action will help and the other will hurt.

Time and compound interest

When you set a longer term horizon and are successful with achieving higher returns, the result is an increased chance of arriving at your financial objectives. It also lessens the probability of running out of money during retirement.

Imagine you have an investor who sets aside a lump sum of £10,000. Take a look at the compound interest chart below to see the influence of time and rate of return.

Compound interest

To ensure you are clear, a lump sum of £10,000 earning 4% per year for the next 50 years would grow into £71,067 if the purchases were made through a tax-free account such as an ISA or SIPP. However, that same £10,000 earning 12% per year for the next 50 years would grow into £2,890,022.  One glance at the compound interest chart and you may want to do whatever it takes to earn the higher rate of return – in this case, 16%. However, remember that the higher the return you aim for, the higher the risk. This risk can be reduced if you hold investments for a long period of time, hence why equity linked investments should be held for a minimum of five years but preferably over 10 years.

Smart income drawdown

Creating a lifetime income is possible if an investor takes the appropriate action to increase their chances of success. When reaching a long-term target, which could be anything from £500,000 to £15 million or even more, a smart investor could set up an automatic withdrawal plan from their ISA and SIPP accounts to pay them an income in order to fund their lifestyle. The guideline rule is to take out a smaller percentage than the rate your account is growing at. If an investor had been making 8% per year over the long term, the guiding rule would be to withdraw maybe 3% or 4%, ensuring that their retirement pot would continue to grow. If they continued to stick with this simple formula, they would eliminate the risk of running out of capital and at the same time creating a continuous stream of lifetime income.

As always, if you have any questions or thoughts on the points I've covered, please leave a comment below or connect with us @ISACO_ on Twitter.

Please note past performance should not be used as a guide to future performance, which is not guaranteed. Investing in Funds should be considered a long-term investment. The value of the investment can go down as well as up and there is no guarantee that you will get back the amount you originally invested.

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Topics: Investment funds, Better performance, Investment strategy, Achieving your investment goals, Creating an income for life