Investors need to rethink pension drawdown strategy

Pay close attention to the level of income you draw in retirement, urges interactive investor's head of personal finance.

The viral overload in the stock markets has left many people in retirement who rely on drawing down an income directly from their pension investments feeling highly uncertain about their finances.

When pension freedoms were introduced in April 2015, over-55s in the UK welcomed the flexibility of being able to withdraw a large lump sum for a trip of a lifetime, or taking a higher income than an annuity would have afforded.

In the first quarter of this year, almost 350,000 people flexibly accessed cash in their pensions, with the average amount withdrawn per individual just over £7,000.

However, the withdrawal strategy has to be managed carefully to make sure your money lasts — and in spite of recent rebounds, the economic outlook casts a long shadow over future investment performance.

Those reliant on a regular income will be aware of the cruel maths that applies after a stock market fall, called pound-cost ravaging. Put simply, if an investment falls in value, it needs to work harder to get back to its initial value. And, crucially, the early years of drawing a regular income from your investments are key to the overall life and success of your retirement portfolio.

In the first three weeks of March, the FTSE 100 index fell by 32%. This would have pushed an initial investment of £100,000 down to £68,000. But to get back to the initial value of £100,000, it needs to grow by 47 per cent (not 32 per cent).

At the time of writing, the FTSE is up roughly 27 per cent from its March low point. But even this puts that portfolio back to £86,000, not £100,000.

Source: FT. Past performance is not a guide to future performance.

The difference is down to “volatility drag” - an evil piece of jargon that even some financial advisers struggle to understand. Its ugly twin sister, “sequencing risk”, is how the order of good and bad returns impacts how long your money will last. Even if poor returns are followed by good returns, if they happen in the early years of your retirement they can have a disproportionately negative impact.

So what can investors do? A traditional method of managing sequencing risk is to keep two years’ worth of essential spending money in cash. This helps you avoid selling down investments to generate income at the worst possible time.

Judging by Interactive Investor’s data on SIPPs, many investors will be OK on this front because they were keeping a significant percentage in cash at the start of 2020. As a result, many are sitting tight, not panicking or making reactive changes to their portfolios.

Traditionally, to lower the risk of money running out over 30 years many people were told to stick to a “safe withdrawal rate”. A common rule of thumb was taking no more than 4 per cent of the overall portfolio value as income per year. In 2017, long before the pandemic, analysts at Aegon and Morningstar concluded in separate studies that “safe” was below 2%.

The alternative is to draw only the “natural yield”, the income generated by the underlying investments. But yields have dropped following a flurry of dividend cuts from UK companies.

We polled our investors at the end of April and found that 5% were looking more globally for dividend paying stocks, while 12% were targeting investment trusts, including the “dividend heroes”.

Others are targeting growth over income. Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB) were the most bought US stocks on interactive investor in April, alongside Zoom (NASDAQ:ZM) and Walt Disney (NYSE:DIS) — no doubt informed by our lives under lockdown — and a strategy that has paid off in the short term at least.

Many fund managers are focusing on the healthcare sector, expecting governments in the developed world to invest more in infrastructure to ensure they are better prepared if the virus returns.

Investors who are happy to risk increasing the proportion of equities held in the early years of retirement can give their portfolio a chance to reverse the effects of pound cost ravaging — after a market fall, you benefit from buying low.

But if you don’t have the risk appetite to make changes, you may have to rein in your income significantly to avoid running out of money.

Life under lockdown has naturally caused spending to fall — expensive holidays and restaurant meals are a distant dream. Many have also focused on trimming their bills and being ruthless with direct debits, as well as paying attention to the costs of investing.

It could also be time for the Bank of Mum and Dad to consider shutting up shop. Can you still afford to give your children a property deposit, or keep investing for the grandchildren? You may need to consider downsizing to a smaller property, or using equity release — which would have implications for what your children would inherit.

It’s a lot to ponder and money conversations with the family over Zoom won’t be as easy as having them face to face. But if you’re worrying, it’s better to have these discussions than to put them off.

You may find that your children weren’t expecting anything, don’t want to inherit the family home and would prefer to see you living in comfort. They may even teach you how to use apps that can reduce your bills, be a sounding board for investment ideas, or help you set up an income-generating hobby — all of which could help you face the future with greater confidence.

Moira O’Neill is head of personal finance at interactive investor, the author of “Finance at 40” and a former winner of the Wincott Personal Finance Journalist of the Year.

This article was written for the Financial Times and published there on 12 June 2020.