Legendary investor and fount of financial wisdom Warren Buffett once said: “Only when the tide goes out do you discover who’s been swimming naked.”
His point was that investors tend to be comfortable with risking money in the hope of a decent investment return when the economy is growing and financial markets rising. It is only in troubled times that some are revealed to have taken more risk than was wise.
A big question in retirement planning is how much investment risk should individuals take?
On the one hand, retirees need a stream of regular income to pay the day-to-day bills that won’t dry up if the economy takes a turn for the worse. On the other hand, investing offers the potential for growing their money over the course of a retirement likely to last two or three decades.
One useful concept to help answer the question is a ‘retirement hierarchy of needs’ which is often represented as a pyramid. This takes a theory proposed by psychologist Abraham Maslow in 1943 to explain human motivation and adapts it to financial planning for retirement.
Maslow thought that humans prioritised meeting their most basic needs – for food, water, warmth and safety – before moving onto achieve more complex needs such as friendships and relationships, feelings of accomplishment and prestige.
A hierarchy of needs for retirement?
For those heading into retirement, the pyramid’s first layer is paying off debt such as credit cards and mortgages. This makes financial sense when the interest payable on the debt is likely to be higher than could be achieved by investing.
Income to meet essential spending is the next layer. Retirees need to put food on the table, maintain a home, clothe themselves and pay utility bills. Some may see activities such as socialising, maintaining a car or travel to see family as largely essential too.
More financial security is offered by a ‘just in case’ fund, usually held in cash, to meet any unexpected expenses. This should be easily accessible and safe from financial shocks.
Once the essentials are taken care of, the remaining layers of the pyramid reflect discretionary spending. The fourth level of the pyramid is the income to meet spending on enjoying life, such as paying for hobbies, eating out, cinema and theatre trips, and holidays.
The top two layers of the pyramid are for gifts – such as helping out family with house deposits or school costs – and for life’s luxuries or ticking aspirations of a ‘bucket list’ such as owning a sports car, dream holiday or meeting another lifetime ambition.
The key message in the pyramid is this split between essential and discretionary spending.
Essential spending is ‘non-negotiable’ and will last for as long as retirement lasts for a retiree and their partner. For most people this should ideally be covered by securing a guaranteed income for life, such as that provided by State Pension, final salary pensions or using a pension fund to buy an annuity.
Once the basics are secured, this gives complete flexibility around the other layers of spending. Once you know, with certainty, that you can always pay the bills, then you have complete freedom to do what you want with the rest whether that is to spend, invest or give it away.
Modern retirements will last two or three decades. That’s plenty of time for economies to grow, but also to spring some unpleasant surprises – as we are reminded by events such as the Global Financial Crash of 2007-08 and the more recent Coronavirus pandemic.
Economic tides do go out. High spirits may excuse young people who are discovered to be swimming naked. Retirees ought to be wise enough not to take the risk.