How to combat drawdown risk

People who are investing in a personal pension such as a SIPP have two main options at retirement:

1. Continue investing and take out money from their pot as and when needed (also known as pension drawdown)
2. 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. 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.

These risks come into sharper focus during volatile periods in markets. Here’s why market falls have such a significant impact on investors using pension drawdown and what might be done to help combat them.

Drawdown risk and what it means to pension investors

1. Volatility drag

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% in one year and rises 10% 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.

2. Sequencing risk

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.

3. ‘Pound-cost ravaging’

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.

Find out more about pound cost ravaging

Tips to combat drawdown risk

1. Keep volatility low

This is easier said than done. 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. There are occasions, though, when correlations between asset classes increase and there are few assets outside cash and high-quality government bonds that provide protection while equity markets fall.

2. Take a sustainable level of pension income

Some have argued that if you withdraw 3% or 4% 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 and there is no ‘safe’ level of income. Much depends on an individual’s other resources and dependable income such as state and defined benefit pensions.

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. That means you income could fluctuate. In good times income could grow as income returns from shares or property rises, but in a market shock or recession it could decline – so that needs to be built into long term plans.

3. 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 or sell-offs in order to help generate more future income.

4. 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 and the larger the buffer you have upon which to draw income, but the rest of the time it can be a hindrance to performance.

5. 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.

Find out more about the Charles Stanley Direct Self Invested Personal Pension (SIPP), which includes a drawdown facility, here.