Reaching retirement can be an exciting time of life, but also nerve-racking as you decide how to survive financially. Faith Glasgow has some great tips on handling your finances once you give up work.
A significant change of focus occurs once you stop working and start to make regular use of your pension fund. It’s not rocket science: you remain invested, but you’re thinking about how to withdraw an income from your fund in such a way that it will see you through 30 or more years.
In the process you may well need to realign your portfolio to some extent, and there are other considerations to bear in mind too once you move into the so-called drawdown stage.
1) Reconsider your asset allocation
Historically, investment portfolios were moved progressively into less risky fixed interest assets as people approached retirement, because the expectation was that they would be used to buy an annuity - an income for life - and therefore capital needed to be protected as the big day drew near.
Such a move would now be considered excessively risk-averse unless you do plan to take out an annuity at retirement. These days, most people switch their (accumulative) pension pot into a drawdown account, where they can easily take money out but leave it invested and hopefully growing.
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That means continuing exposure to equities, which have the potential for capital growth, although you may move more towards equity income funds or dividend-paying stocks that can also deliver an income.
At the same time, you’re likely to increase your exposure to fixed interest holdings, which are less volatile, produce a reliable income and currently offer relatively attractive yields. Opinions differ, but a typical allocation for someone entering retirement might be 50-60% in stocks, with 35-40% in bonds.
The aim is to reduce portfolio volatility once you’re making regular withdrawals, and that means effective diversification across a range of assets, geographies, investment styles and market capitalisations.
2) Don’t forget alternatives
Alternative investments such as property, infrastructure or renewable energy investment trusts can be a useful addition to a retirement portfolio.
There are several reasons. First, provided you buy a fund that invests in the actual projects rather than in the companies building them, you’re further diversifying your portfolio and making it more robust, because these holding are not directly affected by stock market swings.
Second, while capital growth can be minimal in some cases, these funds typically pay generous yields. For example, broker Peel Hunt recently picked out Sequoia Economic Infrastructure Income (LSE:SEQI) investment trust, currently paying an 8% yield.
Moreover, payouts on infrastructure and renewables funds are often at least partially index-linked, so they help you keep up with inflation.
3) Investment trusts are good for income
Once you start drawing an income, you need to be able to rely on it. Ideally, you’ll also see it increasing gradually year by year too, again helping you keep pace with inflation.
In both these respects, investment trusts have a head start over open-ended funds. That’s because their structure as listed companies allows them to withhold up to 15% of revenue each year and hold it in reserve for use in tougher years, when dividends from the underlying companies in the portfolio are down. Open-ended funds, in contrast, are obliged to pay out all the income they receive each year.
The Association of Investment Companies (AIC) has highlighted the most reliable trusts - those that have maintained or increased their dividend for many consecutive years - through their longstanding dividend heroes initiative.
The longest-running equity income dividend heroes now have up to 56 years of unbroken dividend growth, and include City of London (LSE:CTY), JPMorgan Claverhouse (LSE:JCH) (both yielding 4.9%) and Merchants Trust (LSE:MRCH) (4.8%).
The dividend hero trusts’ boards are strongly committed to keeping their track records going, so these are very attractive options for retiree investors.
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4) Consider taking income from capital growth
It can be very useful to look at your portfolio in terms of ‘total returns'. You may draw ‘natural’ income from dividends and interest generated by the portfolio holdings, but there is nothing to stop you topping up with capital growth - it’s all investment profit, after all.
That enables you to widen your net away from high payers and invest in high-quality, strongly performing funds and stocks, even if they are not particularly big income-generators.
Some funds take a similar approach in the way they are run, undertaking to pay a set yield each year which is drawn from both dividends and growth. JPMorgan Global Growth & Income (LSE:JGGI) investment trust, for instance, pays a 4% yield on that basis.
Clearly, though, it’s important to be very disciplined about the amount you take out, otherwise you risk eroding the capital needed to generate those returns.
5) Tread carefully around high-yield investments
It’s a mistake to gravitate straight to the highest-yielding funds or stocks without doing your homework. High yields tend to indicate low share or bond prices, and while that may be because of an indiscriminate market or sector sell-off, it may also be a sign of problems within the company.
In such cases, that generous yield is compensation for the fact that you’re taking on a lot of capital risk. So while you may choose to hold high yield bond or indeed equity funds, limit your exposure, read what the experts say, and understand what you’re investing in before you buy.
6) Don’t over-draw in a falling market
One potential danger is that of so-called pound-cost ravaging. A falling market can do a lot of damage to your retirement capital if you sell units to withdraw your regular amount - say £15,000 a year – from the depleted fund.
Not only has the fund’s capital value in fallen, but you will need to sell more units than usual to release your required sum, thereby reducing it further and locking in those losses.
The danger, particularly early on in retirement, is that the combined losses make it very difficult for the fund ever to recover fully.
Options to protect the long-term value of your fund when markets are trending downwards include drawing only the natural income generated by your portfolio, reducing the amount you withdraw, or if possible leaving it alone altogether and making use of cash savings.
7) Keep cash for market emergencies
As the above point makes clear, as well as running a diversified portfolio holding bonds, equities and alternatives, it’s sensible to keep enough cash to see you through a year or so if need be.
That way, you can leave your pension fund to recover without having to erode it further at its lowest point.
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Cash is also valuable to have in reserve in the normal course of events, of course – not least for the flexibility it provides in timing one-off withdrawals from your investments.
8) Don’t withdraw more than you need
One big concern when pension freedoms were first introduced in 2015 was the extent to which people were taking money out of their pensions and then just leaving it in a savings account. At that time saving accounts really were a waste of time, but even now, although the rates available have improved considerably, they are far below that of inflation, which stood at 10.4% in February.
The upshot is that your retirement savings not only no longer have any chance of capital growth, as they did when they were invested, but they are actually losing value day by day.
It’s therefore sensible to withdraw only the cash you’re likely to need for the coming month or two, unless you have a specific plan for it. You can set up single or regular income withdrawals with the interactive investor , for example.
9) Don’t forget other sources of income
When you’re deciding how much pension income to access on a regular basis, do build in any other income sources you may have, such as state pension, any final salary pension, dividends or interest from ISAs and other investments, or rental income.
You may find that in total you have more coming in than you anticipated, in which case it makes sense to leave as much as possible of your pension invested to grow in its tax-free environment, and focus on other variable income sources first.
10) Think about inheritance issues
There is another reason why it’s best to leave your pension invested as far as possible, if you have other assets to live off. When you die, your pension will be a valuable asset because HMRC will not count it as part of your estate when it calculates inheritance tax.
If you die before age 75, your beneficiaries will receive your pension pot entirely free of tax; if you’re older when you die, they will pay income tax on withdrawals.
It is important in this context to let your pension provider know who your beneficiaries are and keep the details up to date. You’ll need to fill in an ‘expression of wishes’ form from your provider to do this, as your pension (being outside your estate) is not covered by your will. You may need to update it if your relationships change.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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