Pension investors have two main options at retirement: Continue investing and take out money from their pot as and when needed (also known as pension drawdown), or buy an annuity that guarantees a regular income for life. This is a complex issue facing retirees, and any decision to use drawdown must be carefully considered.
Drawdown offers extra flexibility and the potential for better returns and more income from their pension pot - given the relatively low returns on offer from annuities today. However, drawdown is also a risky option. Keeping your pension fund invested means the value can fluctuate according to what markets are doing. You also need to be careful about how much you draw out and when to ensure you leave enough for future needs. Here’s a short summary of some of the issues and the terminology used.
This is jargon for the simple idea that if a portfolio falls in value, it needs to work harder to get back to its initial value. For instance, if a £100,000 portfolio falls 10 per cent in one year and rises 10 per cent in the next, it will not return to £100,000, it will be £99,000.
Most long term investors tend to get used to volatility, and accept that in the long run the destination is more important that the journey. However, for those in drawdown, the journey is just as important as the destination. High volatility increases the chances that you will be taking money out when the portfolio is falling, locking in losses and reducing the chance of there being enough money to meet future needs.
When you are drawing a flexible income from your pension pot it is not just the long-term average return that matters but the sequence of returns. Negative return in the early years can have a particularly detrimental impact on the value of a drawdown fund, even if they are then followed by good returns. Essentially, they have a disproportionate effect on the eventual outcome.
So-called pound-cost ravaging (a play on “pound-cost averaging”, a positive effect of investing regularly) is a term used to describe how the effects of volatility drag and sequencing risk are amplified by withdrawals, potentially derailing retirement plans. Losses created by selling assets to meet income requirements can never be recovered, and taking too much out of a fund just after market falls can damage your wealth and run the risk of exhausting the fund too early.
How to help combat the risks
Keep volatility low
Diversification, populating a portfolio with various asset classes that move independently of one another rather than in unison, can help smooth out returns but without compromising overall performance too much. This can help protect against the dangerous effects of pound cost ravaging.
Take a sustainable level of income
Some have argued that if you withdraw 4 per cent a year from your fund you will be relatively safe, given the normal level of income available and the likely growth rate of dividends. However, assumptions based on long-term averages can be dangerous. It may be that 4 per cent is too high an income to draw while keeping enough of your capital, especially now we have enjoyed a long bull market which has lowered dividend yields. Bond yields are also currently very low by historical standards, limiting income on lower risk portfolios.
One approach is identifying the likely income flows from the investment portfolio and using this as the base case for the amount it is safe to drawdown without eating to any capital. In other words, simply taking the income the portfolio naturally produces rather than committing to a fixed level of withdrawals.
Adapt to changing conditions
Increasing drawdown after a period of good growth in the capital value of the portfolio may be a safer way of avoiding sequencing risk and volatility drag and allow drawdown of some of the capital gains. Similarly, it might be prudent to forego drawing as much income following market falls.
Keep a cash reserve
Keeping a cash reserve in your drawdown pot can help when markets fall or don’t deliver the anticipated level of income. The more cash you hold the less you lose when markets do fall, but the rest of the time it can be a hindrance to performance.
If in doubt seek advice or guidance
Drawdown offers great flexibility and the chance to increase income but it isn’t right for everyone. Investments can fall and you might get back less than you invest. If you do not have sufficient secure resources to cover your essential expenses, or you cannot accept that your income could fall, or even run out, then drawdown is unlikely to be for you and an annuity should be considered.
What you do with your pension is an important decision. We recommend you understand your options and ensure your chosen route is suitable for your circumstances. Take appropriate advice or guidance if you are at all unsure. The government's Pension Wise service provides free impartial guidance on your retirement options, or get in touch with a Charles Stanley Financial Planning consultant.
This article is solely for information purposes and does not constitute advice or a personal recommendation. The taxation of pensions and the rules surrounding them could change in the future. If you are unsure as to whether an investment or a pension is suitable for you, please seek professional financial advice.