Falling markets can have a significant impact on those drawing capital from their pension plans at retirement. If you draw capital when markets fall, you run an increased risk of rapidly eroding your pension and running out of money.
You are locking in the losses and may suffer irreparable damage. Investors who stick to a strategy of taking the natural yield, or even no income at all, during choppy markets can better navigate the challenges.
Withdrawals from pensions are typically done via drawdown, although the new lump sum option of UFPLS (Uncrystallised Funds Pension Lump Sum) can now be used.
When drawing investment income, the underlying investments remain intact and the income from dividends or bonds is used for the withdrawal. This is known as taking the natural yield.
THE RISKS OF DRAWDOWN
The following case study is fictional but possible, showing how large withdrawals can be catastrophic, especially in times of market falls.
A healthy non-smoking man takes his tax-free cash and goes into drawdown on his 65th birthday. He has £250,000 invested.
- Each year, he chooses to draw an income equivalent to the annuity his remaining drawdown fund could buy at that point. In the first three years his fund value falls by 50 per cent. It then makes a modest recovery, before falling again, but by then the damage has been done.
- On day one, the annuity income available is £14,947, paid for life. At the end of 10 years, the annuity his fund could buy is just £8,196 per annum.
The chart below shows the FTSE 100 index from January 2000 to January 2010 (shown in the inset), and compares drawdown income with an annuity bought on day one.
The annuity incomes quoted are for a healthy non-smoker, paying a level income with no death benefits, annually in arrears. The chart assumes annuity rates as at March 2015 for his age and fund value at that point.
As the chart shows, high withdrawals are not sustainable in drawdown, and are made worse by poor investment performance. If this client had decided to take the full £14,947 each year, his fund value would have diminished by almost 80 per cent to £53,331 in the first 10 years.
High withdrawals will significantly impair the ability of the portfolio to recover from the market's inevitable falls.
This case study shows the risks of drawdown. Of course, if you get it right there is the potential for increasing the income and the fund value over time, but the important point for investors to take away is that there are no guarantees.
FIVE STEPS TO PROTECT YOUR DRAWDOWN PLAN
Hold casdh in your pension
Keep at least one year's income (preferably two) in cash in your pension plan; this will serve as a useful buffer during extreme markets.
Drawing cash is unaffected by market movements and this account can be topped up by income generated from investments, such as dividends from shares or yields from bonds.
Limit your withdrawals - review your income
Falling markets could have a significant impact on those drawing too much from their pension plans. Spend too much and the drawdown plan can suffer irreparable damage. If you can afford to do so, stop drawing income: this could help your plan recover.
Draw income, not capital
Volatile markets such as we've seen in recent weeks demonstrate the importance of drawing no more than the income generated from the underlying investments - the natural yield. Spending capital when markets have fallen exacerbates losses. Investors who stick to a natural yield strategy should be better placed to navigate choppy markets.
Diversify your drawdown portfolio
A diverse and balanced portfolio which has a mixture of different investment assets - cash, fixed interest and shares - is likely to be better protected during market falls, and to provide more consistent performance.
Pay in more
Most people under age 75 can pay more into their pension pot and still benefit from tax relief, even if they are not earning.
A £2,880 contribution will be boosted by £720 tax relief to make a total of £3,600. Add this into your pension pot when markets are lower and it will help the drawdown plan make up lost ground as markets pick up.
If you have earnings you can pay in more, but remember those who are drawing income flexibly via drawdown effectively have their contributions to self-invested personal pensions and other money purchase pensions capped at £10,000 a year.
Danny Cox is head of financial planning at Hargreaves Lansdown.