The decisions you make about how best to structure and invest your pension for drawdown over your retirement years, are likely to be amongst the most important financial decisions you will ever need to make.
Unless you are fortunate enough to be able to call upon other substantial sources of guaranteed income – such as a generous final salary pension for example; then the stakes probably couldn’t be much higher. Put simply: making the wrong decisions now and the consequences for many, will probably mean living a less comfortable retirement than had been planned for, or worse still: the prospect of running out of money before you die!
For simplicity here we are going to assume that you have already opted against converting some, or all, of your fund to an annuity, and have decided that the flexible drawdown route is the path that you would like to take. When the government introduced the pension freedoms in April 2015 it is fair to say that more than a few eyebrows were raised within the financial services industry. Previous rules had limited how much an individual could draw from their funds each year having reached retirement; and the main objective of these limitations was supposedly to ensure that the fund could not be exhausted too early into one’s retirement. After all, the last thing the UK government wants is an ageing population that is becoming increasingly dependent on the State – is it not?
Whilst the freedoms have been well received by those reaching or already drawing in retirement, they do increase the stakes for those same individuals to ensure that any financial plan they implement, is done so with a full awareness of the short, medium and longer-term consequences. The decisions taken may well have implications not only for their own futures, but for those of their loved ones too.
What are the main strategies used for drawdown?
Drawdown is now very flexible and provides a number of options for individuals to consider. Whilst there is no single typical profile for a drawdown investor, there are a few common approaches to taking income and these are typically correlated with how your pension fund is structured for investment. These are:
- Leave the fund invested to grow If you don’t have an immediate need for the income and can afford to leave the fund invested then investing for capital growth may still be a sensible option. However, even if you are not yet ready to draw on your funds, ensuring they at least keep pace with inflation will be important so that your money retains its purchasing power. Taking a large cash position for too long in the current low interest rate environment could have damaging effects on the real value of your funds over time.
- Limit withdrawals to only the income from the investments For those that have large enough pots relative to their income requirements, then one option is to draw only the income that the investments produce – known as the natural yield. The fund can be structured to focus on generating a stable (and ideally growing; so as to protect against inflation) income stream. This type of strategy can help allow an investor to shift their attention from the worry about the day-to-day prices of their investments (otherwise known as “market noise”) and keep the focus primarily on the sustainability of the income that is being received. Ask yourself the following question: Do you think a farmer spends his time worrying how much his land is worth each week or will he be more focused on how much income it is producing for him? If he is planning on selling his land some time soon, then maybe he will be keeping an eye on the value, but if not, it is most likely far from his thoughts for as long as the land continues to provide him with a plentiful supply of income. So why then should a good investment strategy be considered any different?
- Draw from the capital Whilst having a portfolio that produces a natural yield of income sounds ideal; the reality is that it won’t always be possible unless the size of your fund is sufficient relative to the amount of income you require. Taking excessive risk trying to chase yield is a game most investors would be wise to avoid. Another option then is to draw part growth (hopefully!) and part capital. This is achieved simply by selling investments periodically to generate income. A word of caution: this is considered a higher risk approach because of the increased risk of running out of capital. It will be important to have a sound understanding of the likely long-term returns of the investment strategy and the amount of income that can be considered “safe” to be drawn from the capital.
Some important considerations
There are various considerations here and in particular this will involve your appetite for risk and your capacity for loss. Appetite or tolerance for risk can be defined as the degree of variability in investment returns that you are willing to withstand. It is important that you have a realistic understanding of your ability to deal with large swings in the value of your investments over time. Taking on too much risk could cause you too panic and potentially sell at the wrong time.
Capacity for loss is slightly different, as this considers your ability to absorb falls in the value of your investments, and whether any loss of capital would have a materially detrimental effect on your standard of living. For example: it is all very well having a high tolerance to risk but if a 20 percent fall in the value of your investments would reduce the available income below a level necessary to fund expenditure, then you will only further exacerbate the problem if you start to withdraw part of the capital.
Consider a lifetime cash flow analysis
If you have a financial adviser, this is where you might want to ask them to provide you with a lifetime cash flow analysis; which by plotting the various inflows and outflows over your lifetime, can provide visibility and clarity on how decisions taken today can affect your future. This can help you to align your finances to meet your goals.
Ensure you have diversification
It is a basic fact that all investments carry risk. While investment risk cannot be removed completely, by spreading your money in a range of investments you can reduce its effect through diversification. However for diversification to be effective, an understanding is required between the correlations that exist between different asset classes and the market forces that drive their returns. If your portfolio is invested in five different funds, but they all happen to be invested in UK equities, then that is not effective diversification. You will do well to keep in mind that a portfolio whereby everything goes up at the same time can quickly turn into a portfolio where everything goes down at the same time.
True diversification comes when the portfolio has exposure to a range of assets that are driven by different market forces; each asset class will go through periods of positive and negative performance, but rarely all at the same time. If constructed properly then this can provide a smoother ride – especially when things take a turn for the worse. If this is an area you not fully comfortable with you should consider seeking professional advice. Sure, you will probably need to pay a fee, but when financial markets can move 20 percent or more in a matter of weeks (or less in extreme conditions), paying for good quality specialist advice should be worth a great deal more to you in the long run than the initial or ongoing cost of obtaining it.
Keep some cash
It would be considered prudent for any drawdown investor to consider holding at least one years’ and possibly two years’ income as cash; closer to two years if your investments are not producing sufficient natural income and you are going to be more reliant on growth to fund withdrawals. This will let you draw the income you need without having to sell any of the investments – something that will be particularly helpful if markets should fall. Knowing when these events will happen in advance is impossible; and anyone who tries to tell you any different should not be trusted to provide you with any financial advice!
However, while cash will offer liquidity and a buffer from volatility, it is typically a short-term strategy and especially in such a low interest rate environment; as inflation will usually erode the value in real terms if more than necessary is held over longer time periods.
Should I take financial advice?
Whilst DIY investing has become increasingly popular since the last economic crisis, and the range of tools available to help investors make decisions of their own is greater than ever; care obviously needs to be taken that any major decisions you make are done so with a genuinely sound understanding of the implications. If your investment holdings are largely based on “top tips” from financial columns or from looking over lists of “best performing funds” you might want to take a step back before committing to any plan. If successful investing really was that simple, there would only ever be one fund that everyone needed to invest in – its called “the top historical return fund!” Taken in isolation this kind of investment strategy is a little but like driving down the motorway at 80 mph whilst looking in the rear view mirror!
For an experienced and intelligent investor (and by that we are not referring to your IQ here) then the DIY route can save extra costs that will go towards yield and performance; but for those with less experience, or those that simply are not able to allocate sufficient time to the task to do it justice, then working with an investment professional should reap you far more rewards in the long term than will be required to pay for the privilege of the advice in the first instance.
Let us help
At First Equitable we are passionate about building long lasting relationships with our clients and helping them achieve their financial goals and objectives. We believe that income drawdown is one key area where the expertise of a professional and experienced financial adviser can really add value for a lot of clients.
If you would like to find out more about how we can help you make intelligent financial decisions; or if you would simply like to have an initial chat or ask us some questions: please give us a call, or you can fill out a contact form and we will do the rest.