Article

The ‘stealth’ risk stalking investors drawing from their pension pots

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

| 5 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 – and it’s an area where the right advice can be invaluable.

Options at retirement

Pension investors have two main options at 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 of on investors taking regular or ad hoc withdrawals.

What’s the problem?

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.

When you are drawing 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 examples.

The first column in the table below shows a steady return of 5% for 10 years, and the second and third columns show the same overall level of growth over 10 years but received unequally, the first with better returns in the early years, the second with better returns coming after some difficult early years. If no withdrawals were taken, each of the end fund 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 for someone making regular withdrawals – something known as ‘sequencing risk’.

‘Volatility drag’

Taking withdrawals during volatile markets (with greater ups and downs) also means the remaining pot must work harder to get back to where it was – an effect known as ‘volatility drag’. 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. High volatility increases the chances of taking money out when the portfolio is falling, locking in losses and reducing the chance of there being enough money invested to meet future needs.

‘Pound-cost ravaging’

So-called pound-cost ravaging is a term used to describe how the effects of sequencing risk and volatility drag are amplified by regular withdrawals, potentially derailing investment plans. Unlike ‘pound-cost averaging’, which describes the positive effect of investing regularly in volatile markets, losses created by selling assets regularly to meet income requirements has the reverse effect. Taking too much out of a fund just after market falls can run the risk of exhausting an investment portfolio too early.

What’s the solution?

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 on the higher withdrawals are – so it’s important to consider the sustainability of withdrawals in the context of risk and overall circumstances.

Ultimately, though, managing a portfolio to provide 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. If you want to make the most of securing an income from your investments, it may be worth speaking with one of our expert financial planners who can look at your situation in detail and come up with a bespoke plan. There’s more details on our financial planning service and how to arrange an initial consultation here.

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.

The ‘stealth’ risk stalking investors drawing from their pension pots

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