Retirees need to withdraw money from their pensions to live on, but how much can they take out regularly with-out eroding their pension pots too quickly? With the introduction of pension flexibility, one of the biggest dangers to people’s retirement pots is so-called pound-cost ravaging.
Pound-cost ravaging occurs when you draw an income higher than the ‘natural’ income generated by the holdings in your portfolio, after markets have fallen. Your pension pot’s value can quickly dissipate because units have to be sold cheaply to maintain your desired income. A severely reduced fund may have little potential to recover.
If you are lucky enough to start your income drawdown plan when markets are rising, your early capital gains allow you to withdraw the income you require and still enjoy capital growth – so you have a larger base from which to generate both income and gains in future. But those who suﬀer a few bad years at the beginning of their retirement risk depleting their capital. Markets then need to perform heroically to return the diminished pot back to its original value.
Peter Savage, chartered financial planner at Fairstone, says: ‘I explain to my clients that for them to have the retirement they want and need, the sustainability of their fund is key. When people retire, they assume a steady rate of return in their retirement projections, but this doesn’t take into consideration the fact that the market doesn’t provide consistent returns’
The natural way
For those who can aﬀord to, withdrawing only the natural income or yield from underlying investments is the best option, because it leaves capital intact. The downside of only taking the natural payout from your portfolio is that your income will fluctuate. Indeed, when markets fall, savers using this strategy may not be able to draw any in-come at all.
However, Dean Mullaly, managing director at Mark Dean Wealth, agrees that this strategy is a good one for guarding against pound-cost ravaging. He says: ‘If you withdraw only natural income from your portfolio (the dividends produced by the underlying holdings in your drawdown plan, and not a penny more), your income will vary, but at least your pension should last for the rest of your life, and when the time is right in the future, you can buy an annuity.’
The 4 per cent rule
Some advisers suggest that 4 per cent is the magic number when it comes to drawdown income. You may eat into capital to some extent, but the rule of thumb is that if you draw 4 per cent from your portfolio as income, the likelihood of you running out of money within 30 years is small.
But is this strategy a better one than withdrawing an unpredictable natural income? ‘The 4 per cent rule is part of the answer, but not all of it,’ says Anna Sofat, managing director at Addidi Wealth Management. ‘Our analysis of markets going back to 1900 shows that there is a 25 per cent likelihood that a withdrawal rate of 4 per cent will completely deplete a pot in 30 years.’
These figures assume a 60/40 ratio of equity to bonds and gilts in the portfolio. Sofat explains that this is the minimum risk you need to take to make the 4 per cent strategy work, because you need the typically bigger returns produced by equities to replenish your pot. Invest more cautiously than this and you will need to reduce the amount of income you take.
A more flexible approach to the standard 4 per cent rule may be preferable. Sofat recommends what she calls a ‘dynamic 4 per cent’ approach. It works as follows: in bad years, when markets are falling by 20 per cent, trim your withdrawals to 3 per cent; in years when markets fall by 40 per cent, reduce your withdrawals even further to just 2 per cent of your portfolio. With this strategy the likelihood of your pot being completely depleted in 30 years is just 3 per cent, according to the research. Over 20 years the likelihood of you running out of cash is zero.
‘The dynamic 4 per cent strategy helps tackle the pound-cost ravaging risk for drawdown investors. It’s the impact not just of how big market falls are and how often they happen, but also of when they happen,’ adds Sofat. ‘If investment returns were consistent, managing your drawdown portfolio would be easy. But they aren’t.’
By cutting withdrawals in the bad years, you have a bigger stake in the market to capitalise on the rebound when it comes. Sofat also points out that a flexible approach is better than opting for a lower but consistent withdrawal rate. ‘You might think adopting a smaller fixed withdrawal rate, of say 3 per cent, would be better. But our analysis shows that a dynamic 4 per cent strategy, falling to 3 or 2 per cent in bad years, works better.’
Count on cash
It is worth holding cash to fall back on for income in the event of a market slide, so that your full pension fund can be left to recover. To protect your pot in diffi cult years, you should hold at least one year or ideally three years’ worth of income in cash. ‘That way, when you fl ex your income down to 3 or 2 per cent during bad years, you can replace the lost income from the cash buff er and replenish it in good years,’ says Sofat.
Thus a person with a £500,000 pot would take 4 per cent, which would be £20,000, in good years, but if a 2 per cent withdrawal were triggered, they would take £10,000 from the drawdown pot and £10,000 from their cash buffer.
‘In most scenarios, you won’t need to dip into the pot for more than a few years, though the bigger the cash buffer you have, the more secure the strategy,’ Sofat says. As you get older you will be able to adapt your strategy and either use your capital or buy an annuity as age-related annuity rates become more generous.
Alternatively, annuities can be used to provide a secure core income. Having an annuity means you rely less on your drawdown plan, and the need to maximise income from your pension pot in difficult market conditions is lessened. Mullaly agrees that annuities can be very beneficial, although he admits ‘rates don’t look great at the moment’.
Pension pot diversification is crucial, as always, and a good balance needs to be struck between equities – which are riskier but may produce higher returns – and safer assets. Savage says: ‘Look at having a good mix of assets: shares, bonds, property, commodities and alternatives. What you don’t want are assets that are highly correlated [with one another].’
He aims to make pension pots sustainable by using lower-risk asset classes in the portfolio. He says: ‘Traditionally, this may have involved including more bonds, but given the bond bubble we have experienced over the past 30 years, bonds may not behave as a low-risk asset over coming years. I would recommend low-risk alternatives that are not correlated with equities or long-dated bonds. These low-risk alternatives would be absolute return bond funds.’
If the income you needed is higher than the yield your lower-risk portfolio provides naturally, Savage recommends encashing the lower-risk assets first.
He explains: ‘For example, the first three years’ worth of income should be invested in cash. Then cash in the next lowest-risk asset class, such as bonds or alternatives, to provide another two to four years of income. This then allows the equity proportion of the portfolio to grow for a good five to seven years before it is encashed. So if there is a fall in equity markets in the early years, the equity component of the portfolio will have enough time to recover before you need to encash any equity units.’
Falling markets take toll on new retirees
This example (using data provided by Old Mutual Wealth and FE Analytics) illustrates the detrimental effect pound-cost ravaging can have on your pension pot if you happen to start drawing an income when markets are falling.
Peter Savage compares Frank, who retired in 2007, with Derek, who retired in 2009. Both retirees started out with £100,000 pension pots and make annual withdrawals of £5,000, split monthly. In both cases, the pension is invested in an average mixed-asset fund (Investment Association mixed investment 40-85% shares sector).
Frank drew income between 11 October 2007 and 11 October 2012, so his pension was invested at the peak of the market, just as it began to fall. This fall continued until 2009 before a recovery began. Derek drew income between 6 March 2009 and 6 March 2014, so he entered the stock market at the very bottom when it was starting to recover, and he enjoyed positive returns early on. It wasn’t until 2011 that he experienced a negative return.
After five years, Frank’s pot had shrunk to £79,561, while Derek’s had grown by more 50 per cent to £153,292. The difference in their fortunes reflects the contrasting market conditions each experienced when they entered retirement.
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