I was drawn to the following article in last week’s Sunday Times because Adam and I have been doing some work on just this for a client who is contemplating taking a substantial regular income from his Pension Fund. The article highlights the surprisingly different retirement someone might enjoy, depending on whether investment returns are good or bad during the early stages of the withdrawal process.
Most financial planning tools are deterministic in that they assume investment growth is delivered in a nice orderly fashion but nothing could be further from the truth of course; it is common to see double digit rises or falls in year, only for the long term average to remain fairly stable. We need to be cognisant of this when helping clients devise a strategy that allows them to live a full life without fear of, either running out of money, or dying with too much and leaving dreams unfulfilled. It can be something of a tightrope and it is why Financial Planning must be a dynamic process and not just a one-off exercise.
Timing is everything when you think about taking your pension – Imogen Tew
“There are many things you have to think about when investing in retirement: how your money will fare in the stock market, how long you may need an income for and whether the amount you withdraw from your pot each year is sustainable.
The calculations do not stop there, though. You must also think about timing, because the rhythm of stock market changes can have a huge impact on how long your pension pot lasts.
This is called “sequencing risk”. It is created by the timing of weak or strong years of investment returns as you start to spend your pot. Weak or negative investment performance in the early years will have a much bigger impact than if it happens later, because of compounding.
In rising markets your pot will earn interest, and then interest on that interest if it is reinvested. If you start withdrawing money when markets are falling, your pot will shrink faster, and the results can be calamitous, as figures from the pensions company LV show.
After 15 years, a £200,000 pension pot, averaging 5 per cent growth a year and providing a £12,000 income, would be seven times bigger if it delivered strong investment growth and then made losses, compared to making a weak start at the beginning of your retirement.
If the pot had investment growth of 20 per cent in the first year, then settled to average 5 per cent growth across the 15 years, it would grow to £232,963. If it took a 20 per cent hit in the first year but still averaged 5 per cent growth over 15 years, it would deplete to £32,585, despite both pots averaging 5 per cent growth a year.
Sequencing risk is often overlooked in retirement planning, but management of income withdrawals can have a huge impact on how long your pension pot lasts.
When markets fall and you sell investments to provide an income, it amplifies the impact because more investments would have to be sold at the lower value to provide the level of income.
You can expect a £200,000 pension pot to last 31 years, assuming that you take an income of £12,000 and have growth of 5 per cent a year. The same pension would run out after 16 years if your money took a 20 per cent hit initially and averaged 5 per cent over the first 15 years.
There is nothing you can do about the market falling as you hit retirement, but you can take steps to mitigate the impact. Here is how.
A sustainable income
In any market conditions you should ensure that you are drawing a sustainable income. This means ideally living off just the yield of your investments to begin with, and drawing down capital later in your retirement.
Taking 4 per cent from your pot each year is typically considered a safe bet because your investments are likely to earn this back in growth (although nothing is guaranteed).
If markets are falling, could you reduce the amount you take to, say, 2 per cent? This would minimise the impact on your pot and is known as dynamic spending, where you take a flexible approach to how much you withdraw.
If you are aiming to live just on the yield from your pot, you can calculate roughly how much you will have by looking at previous years’ yield.
It pays to have some fixed- income assets and to invest in companies that pay dividends which can help to maximise the income from your pot.
Look elsewhere
If you have other sources of income, such as an annuity or a final salary pension, they could see you through a market downturn so that you don’t have to take money from a pot invested in the stock market.
Laith Khalaf, a financial analyst at the wealth manager A J Bell, recommends keeping a cash buffer in your fund, even in retirement, to see you through any market downturns.
Allocating assets
A well planned pension strategy, with enough of your portfolio allocated to liquid assets, can help to mitigate sequencing risk, according to Greg Winter from the wealth manager Tilney. By having some of your pot invested in more liquid assets such as bonds, which are less volatile and should behave differently to equities in times of market stress, you might meet your short-term needs without having to sell equity-based investments to maintain your income. A multi-asset fund, run by a fund manager who switches between markets, could be a solution.”
Current Pensions legislation allows for withdrawals to be adjusted up or down to suit prevailing conditions and also for ad hoc withdrawals to be taken, where appropriate. This flexibility coupled with regular planning reviews should ensure that we are able to help our clients walk the retirement income tightrope with a degree of confidence.
I hope you fund the above of interest but please do not hesitate to contact me if you have any concerns or questions relating to anything in this e-mail or indeed any other finance related matter.
Yours sincerely,
Graham Ponting CFP Chartered MCSI
Managing Partner
