Article

Pound cost ravaging: the ‘stealth’ risk stalking pension investors

Rob Morgan explains how ‘pound cost ravaging’ affects investors who take regular withdrawals from their investments.

| 7 min read

The subject of how to build up investments tends to receive a lot of attention, but often much less time is spent talking about how to best take money out. It’s vitally important, though, especially for those relying on pensions and other investments to help provide an income in retirement. With the risks of pound cost ravaging at large, which I’ll explain as we go on, and the impact it can have on an investor’s pension pot, planning retirement income is an area where the right advice can be invaluable.

What are the options at retirement for pension investors?

Pension investors have two main choices when they reach 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.

In particular, when market volatility strikes, there can be a significant impact on investors taking regular or ad hoc withdrawals. You can find out how much income you may need during retirement using our pension drawdown calculator.

Pound cost ravaging – the stealth risk to investors

Volatile markets on graph

Upping withdrawals, or even continuing to take the same level of income, during periods of market stress can mean a portfolio drains much quicker than anticipated, making it very difficult - if not impossible - for it to recover. It’s important that poor returns and taking too much income, something known as ‘pound cost ravaging’ don’t combine to drain a retirement pot.

When you are drawing a fixed sum from a portfolio it is not just the long-term average return that matters but the sequence of returns. Negative returns earlier on can have a particularly detrimental impact on the value of a pot, even if they are then followed by good returns. It’s a difficult concept to explain so it’s best to use some comparative examples.

  • The first column in the table (see below) shows a steady return of 5% for 10 years, and the second and third columns show the same overall level of growth (on average) over 10 years but received unequally, the second with better returns in the early years, the third with better returns coming after some difficult early years.
  • If no withdrawals were taken, each of the end values after 10 years would be almost the same (just over £162,000). However, despite the same overall growth rate different sequences of annual returns provide entirely different outcomes in terms of the residual pot for someone making regular withdrawals – something known as ‘sequencing risk’.
  • Investor C has depleted their capital in the early years through taking income when returns were poor, while investor B with exactly the same income strategy has ended up with a larger pot than when they started.

How the sequence of returns effects the value of a £100,000 portfolio providing income

Compound annual growth rate of 5% compared with two variations averaging around 5% per annum; annual withdrawal of £5,000 a year.

This illustrates that the sequence of returns you get when managing the investments you are drawing income from can matter a lot. Controlling volatility in a portfolio through asset allocation can therefore be very important.

Pension income withdrawal strategies to combat pound cost ravaging

The world is always uncertain. We can’t expect returns to be linear because real life presents a randomness of returns and volatility. It’s impossible to eliminate this altogether – it is part and parcel of investing. However, a portfolio well diversified across various assets to smooth returns can reduce the likelihood of a poorer outcome from the stealth ‘ravaging’ effect. Ensuring losses are kept to a minimum in the early years can be particularly important.

More flexibility also helps, such as reducing income withdrawals in particularly bad years. Pound cost ravaging has a greater impact the higher withdrawals are – so it’s important to consider the sustainability of withdrawals in the context of risk and overall circumstances.

You could also keep a cash buffer to avoid having to cash in investments at an inopportune time, though this can reduce the overall returns from the pot in the longer term. Another strategy is to withdraw just the income that your chosen investments provide, thereby keeping capital intact. However, that may constrain your investment selection and mean your income varies according to what is produced.

Ultimately, managing a portfolio to provide retirement income effectively can be much more complex and challenging than investing for growth. An appropriate, sustainable withdrawal strategy is as important as a sensible investment strategy – if not more so.

Take advice when you need to

Couple getting financial advice at a restaurant

Retirement planning can be complex, but you don’t have to tackle this on your own. There are free resources such as the government’s Moneyhelper service. Meanwhile, our One Step Retirement Plan can assist you in creating a tailored financial plan with our expertise. It can help you:

  • Create a realistic plan about how much income you can draw without you risking that you will run out of money.
  • Navigate the rules and regulations to avoid making any wrong decisions now which could be expensive and leave you with less flexibility later.
  • Explore your options so you know the best way to draw on your savings and don’t pay more than your fair share of tax when taking an income.
  • Review your investments to make sure they aren’t too risky for you, while also balancing this with the opportunity to grow your wealth in the future.
  • Take into consideration inheritance tax within your plans so you can leave money to your family in the most efficient way.
  • Gain financial peace of mind that you can afford the retirement lifestyle you want.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Will you have enough for the retirement you want?

When it comes to planning your retirement, you can’t afford to leave anything to chance. We’ll help you take control, so you have financial security and flexibility over when and how you retire.

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Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.

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