We chart how market swings from 2000 to 2010 would have affected an invested pension vs someone who bought an annuity
Retirees can cause irreversible damage to their pension pots if they withdraw at the wrong time.
Swathes of ordinary people can now follow
the example of the wealthiest savers who invest their retirement fund
and live from the proceeds.
Many of
these ordinary people, though, will have to do without the professional
advice and guidance that the richest can afford.
Before important changes to pension rules came into effect this year,
most ordinary savers would have swapped the savings they had accumulated
during their working life for an annuity, which takes all your pension
pot and gives you an income for life in return.
That income may have been disappointing, particularly after rates
collapsed following the financial crisis, but it was guaranteed and
removed the possibility of making mistakes that could mean your pension
ran dry early.
Following the changes
in April, however, more people will now draw an income from their
pension while the bulk of the capital remains invested, benefiting from
the growth that history suggests long-term investors enjoy if they can
avoid handing all their money to an insurance company.
They can do this through a “drawdown” scheme or by using the new flexibility to withdraw lump sums when they need them.
This second option – known technically as “uncrystallised funds pension lump sum" or UFPLS – has been likened to using your pension as a bank account. As with drawdown,you leave the balance of your pension savings invested to grow, selling part of your pension pot when you need cash. The main difference between drawdown and UFPLS is with the former you take your 25pc tax-free lump sum in one go at the outset, whereas with the latter each withdrawal includes a 25pc tax-free element.
However savers decide to draw money from their pension, there’s a risk that too much is taken, the pot dwindles and future income is cut dramatically as a result. That risk is even more acute during periods of stock market turmoil, as we have seen in recent weeks.
Seasoned investors sit tight, knowing some of the best days for markets follow immediately after some of the worst (as we have also seen recently). Panic and you risk selling when prices have fallen and missing any bounce.
A similar misfortune can befall those who use their investments to generate an income – including those in drawdown. The income they wish to take, and assume is reasonable, is often not generated naturally by their investments but requires that they regularly sell assets to be sustained.
Fine if prices are rising and the value of the pot is maintained, but sell after a market fall and you are punished twice: by the price fall and your pot having fewer assets – the number of shares or fund units owned – when prices do recover. Put another way, to generate a given sum when markets have just fallen, you need to sell more units or shares. This is known as “pound cost ravaging”.
Even those withdrawing what seem reasonable amounts can be caught.
The firm looked at 2000 to 2010, a period that included heavy market falls, to highlight the risk. It imagined a 65 year-old man with £250,000 of pension savings after any tax-free cash had been taken. In 2000, he had the option of taking the best “level” or fixed annuity he could find; this would have paid £15,000 a year (represented by the purple line on the chart below).
But he chose to enter drawdown, withdrawing the £15,000 the annuity would pay that year and leaving the rest invested, hoping it would grow. His withdrawal was not even the maximum allowed at the time. After a year he continued his plan and withdrew an amount equivalent to the best annuity his pot could buy (represented by the yellow line).
Withdrawals and falls in the stock market meant that, in three years, his fund (represented by the blue area) lost more than 50pc of its value. After 10 years, even with periods of rising prices, it was just £102,000. At that point, assuming he cut his losses and bought an annuity, he could have expected just £8,200 a year, 45pc less than available at the start of his retirement. (See chart).
Danny Cox, head of financial planning at Hargreaves Lansdown, says: “This example is extreme but the point is withdrawing unsustainable sums leaves you vulnerable if the market falls.’’
Ned Cazalet, a pensions consultant who has advised the Treasury, says: “If you can survive without all your dividends and reinvest them, then great. If you need to take dividends as income, fine. But if you need to start living off capital it’s very dangerous.”
Mr Cox recommends keeping at least a year’s worth of income in cash, or even two. “Drawing cash is unaffected by market movements and this account can be topped up by income generated from investments, such as dividends from shares or interest from bonds,” he says. If your circumstances allow, periods when markets are depressed can be an opportunity to pay more into your pension at knock-down prices. Just as the hit to those withdrawing capital after prices have fallen is magnified, so too is the benefit to those paying more in.
Most people under 75 can pay more into their pension and still benefit from tax relief, even if they are not earning. If you are drawing income flexibly via drawdown from Sipps (self-invested personal pensions) or other “money purchase” (“defined contribution”) pensions, contributions are capped at £10,000 a year.
He said: “My advice to the trustee could not be more simple: put 10pc of the cash in short-term government bonds and 90pc in a very low-cost S&P 500 index fund.”
He even tipped a particular tracker fund: “I suggest Vanguard’s.”
His plan is a variation of the cash buffer. Essentially, it allows the bulk of money to remain invested. This portfolio will produce some income naturally and the extra 10pc in short-term government bonds will regularly release more cash if it’s needed. Short-term bonds suffer only very slight price variations even if the wider bond market is very volatile, so they behave in effect as cash.
Culled from Telegraph
This second option – known technically as “uncrystallised funds pension lump sum" or UFPLS – has been likened to using your pension as a bank account. As with drawdown,you leave the balance of your pension savings invested to grow, selling part of your pension pot when you need cash. The main difference between drawdown and UFPLS is with the former you take your 25pc tax-free lump sum in one go at the outset, whereas with the latter each withdrawal includes a 25pc tax-free element.
However savers decide to draw money from their pension, there’s a risk that too much is taken, the pot dwindles and future income is cut dramatically as a result. That risk is even more acute during periods of stock market turmoil, as we have seen in recent weeks.
Seasoned investors sit tight, knowing some of the best days for markets follow immediately after some of the worst (as we have also seen recently). Panic and you risk selling when prices have fallen and missing any bounce.
A similar misfortune can befall those who use their investments to generate an income – including those in drawdown. The income they wish to take, and assume is reasonable, is often not generated naturally by their investments but requires that they regularly sell assets to be sustained.
Fine if prices are rising and the value of the pot is maintained, but sell after a market fall and you are punished twice: by the price fall and your pot having fewer assets – the number of shares or fund units owned – when prices do recover. Put another way, to generate a given sum when markets have just fallen, you need to sell more units or shares. This is known as “pound cost ravaging”.
Even those withdrawing what seem reasonable amounts can be caught.
How much can it hurt your pot?
Modelling by financial advisers at Hargreaves Lansdown has shown how a fund will dwindle if markets turn against you, even if you are withdrawing sums that compare with the rates available on annuities.The firm looked at 2000 to 2010, a period that included heavy market falls, to highlight the risk. It imagined a 65 year-old man with £250,000 of pension savings after any tax-free cash had been taken. In 2000, he had the option of taking the best “level” or fixed annuity he could find; this would have paid £15,000 a year (represented by the purple line on the chart below).
But he chose to enter drawdown, withdrawing the £15,000 the annuity would pay that year and leaving the rest invested, hoping it would grow. His withdrawal was not even the maximum allowed at the time. After a year he continued his plan and withdrew an amount equivalent to the best annuity his pot could buy (represented by the yellow line).
Withdrawals and falls in the stock market meant that, in three years, his fund (represented by the blue area) lost more than 50pc of its value. After 10 years, even with periods of rising prices, it was just £102,000. At that point, assuming he cut his losses and bought an annuity, he could have expected just £8,200 a year, 45pc less than available at the start of his retirement. (See chart).
Danny Cox, head of financial planning at Hargreaves Lansdown, says: “This example is extreme but the point is withdrawing unsustainable sums leaves you vulnerable if the market falls.’’
Ned Cazalet, a pensions consultant who has advised the Treasury, says: “If you can survive without all your dividends and reinvest them, then great. If you need to take dividends as income, fine. But if you need to start living off capital it’s very dangerous.”
So what can you do?
While anyone drawing from their pension via these methods is exposed to investment risk, there are steps to take to give yourself flexibility that reduces the need to sell assets at exactly the wrong time.Take only ‘natural’ income
A portfolio of investments will include assets that yield an income, either through dividends from shares or bonds that pay holders interest. Equity income funds, for example, produce a typical yield of 3.5pc to 4pc of the amount invested. Keeping your income to this level means you won’t need to sell fund units when markets fall and there’ll be a better chance your pot will recover if they bounce. Most drawdown plans include a facility that pays the income into a cash account. Withdraw only from this and there is no need to sell out.Build a cash buffer
It is possible to hold cash in your pension, alongside stocks, bonds and other assets. A cash buffer can be the difference between having to sell your investments at the wrong time, or not.Mr Cox recommends keeping at least a year’s worth of income in cash, or even two. “Drawing cash is unaffected by market movements and this account can be topped up by income generated from investments, such as dividends from shares or interest from bonds,” he says. If your circumstances allow, periods when markets are depressed can be an opportunity to pay more into your pension at knock-down prices. Just as the hit to those withdrawing capital after prices have fallen is magnified, so too is the benefit to those paying more in.
Most people under 75 can pay more into their pension and still benefit from tax relief, even if they are not earning. If you are drawing income flexibly via drawdown from Sipps (self-invested personal pensions) or other “money purchase” (“defined contribution”) pensions, contributions are capped at £10,000 a year.
Try the Warren Buffett method
Last year, Warren Buffett, probably the world’s most renowned investor, wrote to shareholders of his company, Berkshire Hathaway. He relayed to them the advice he had given the executors of his will on how money he left to his wife should be invested for her retirement.He said: “My advice to the trustee could not be more simple: put 10pc of the cash in short-term government bonds and 90pc in a very low-cost S&P 500 index fund.”
He even tipped a particular tracker fund: “I suggest Vanguard’s.”
His plan is a variation of the cash buffer. Essentially, it allows the bulk of money to remain invested. This portfolio will produce some income naturally and the extra 10pc in short-term government bonds will regularly release more cash if it’s needed. Short-term bonds suffer only very slight price variations even if the wider bond market is very volatile, so they behave in effect as cash.
Culled from Telegraph
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