Long-term outcomes for your pension pot are heavily influenced by returns in the early years of retirement – but how can you protect yourself?
Beware of projections that use average rates of return to suggest how long your retirement pot might last at a given rate of withdrawal: the returns generated in the early days will have a disproportionate effect on how far your money will go.
According to models supplied to Money Observer by Old Mutual Wealth, someone with a £250,000 retirement pot who takes £12,500 income each year for 10 years will end up with £219,985, assuming regular annual returns of 4 per cent.
However, when we look at two different models where the average annual return is 4 per cent but the weighting of returns over the years differs, it becomes clear just how different the outcomes can be with different starting market conditions.
In one model (still maintaining an average annualised return of 4 per cent), returns start strong at 15 per cent for the first year and decline over the 10-year period, to end with a loss of 20 per cent. After the tenth year the investor's pot is worth £237,485.
However, if the rates of return are reversed so that the weak returns come in the earlier years, the same investor will wind up with only £161,925 left in his or her pot.
'This simple example illustrates the fact that the impact of short-term investment losses is amplified dramatically if it occurs when an individual begins to withdraw capital from their pension savings,' says OMW retirement planning expert Adrian Walker.
'When investors are building their pension savings and not taking income, losses in some years are likely to be countered by gains in other years, leading to long-term investment growth with no real detriment to the long-term value of those savings. However, once in retirement, the impact of withdrawing income in a falling market means the portfolio value can be significantly impacted over the long term.'
Two potential solutions for this include keeping aside a cash reserve to tap during downturns or flat periods, and investing in a portfolio designed to minimise volatility.
Using the bear market example where poor returns come in the early days, OMW ran the same calculations but allowed its hypothetical investor to hold £50,000 in cash and £200,000 in investments.
After ten years, the cash pot was empty but £181,915 remained in the investment portfolio.
However, one of the drawbacks of this method involves the notorious difficulty of timing the market – how do you know when it will turn around and therefore how much cash you should draw?
The other option is a low-volatility portfolio that aims to soften the downside – at the expense of also dulling the upside.
In a scenario where the poor returns come first but are not as pronounced, and the eventual positive returns are also more moderate, OMW found that the investor wound up with £181,006 after 10 years.
A combination of these two strategies is even more effective: using a combination of holding a cash reserve and investing in a low-volatility portfolio resulted in a remaining pot of £192,237 after 10 years.
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