25th August 2015
Danny Cox, head of financial planning at Hargreaves Lansdown, looks at the impact of Monday’s market falls on pensions and provides a five-point guide to how you can protect your drawdown plan….
Falling markets can have a significant impact on those drawing capital from their pension plans at retirement. If you draw capital when markets fall you run an increased risk of rapidly eroding your pension and running out of money. You are locking in the losses and can suffer irreparable damage. Investors who stick to a strategy of taking the natural yield, or even no income at all, can better navigate choppy markets.
Withdrawals from pensions are typically done via drawdown, although could also be done via the new lump sum option of UFPLS (Uncrystallised Funds Pension Lump Sum).
It is important to note the distinction between drawing capital – which means selling investments to fund the withdrawal – and drawing investment income, where the underlying investments remain intact and the income from dividends or bonds is used for the withdrawal. This is known as taking the natural yield.
The risks of drawdown – an example
The following case study is fictional but possible, showing how high withdrawals can be catastrophic, especially in times of market falls. It shows the FTSE100 index from Jan 2000 to Jan 2010 (FTSE 100 over this time shown in the inset), and compares drawdown income with the annuity that might have been bought on day one. This case study brings home how high withdrawals are not sustainable, particularly in times of sharp market falls.
Five point action plan to protect your income drawdown plan:
1. Hold cash in your pension
Keep at least 1 year’s income (preferably 2) in cash in your pension plan, which will serve as a useful buffer during extreme markets. 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 yields from bonds.
2. Limit your withdrawals – review your income
Falling markets could have a significant impact on those drawing too much from their pension plans. Spend too much and the drawdown plan can suffer irreparable damage. If you can afford to do so, stop drawing income, this could help your drawdown plan recover.
3. Draw income not capital
Volatile markets such as these evidence the importance of drawing no more than the income generated from the underlying investments, the natural yield. Spending capital when markets have fallen exacerbates losses. Investors who stick to a natural yield strategy should be better placed to navigate choppy markets.
4. Diversify your drawdown portfolio
A diverse and balanced portfolio which has a mixture of different investment assets – cash, fixed interest and shares – is likely to be better protected during market falls and provide more consistent performance
5. Pay in more
Most people under age 75 can pay more into their pension pot and still benefit from tax relief, even if they are not earning. A £2,880 contribution will be boosted by £720 tax relief to make a total of £3,600. Add this into your pension pot when markets are lower and this will help the drawdown plan make up lost ground as markets pick up. If you have earnings you can pay in more, but remember those who are drawing income flexibly via drawdown effectively have their contributions to SIPPs and other money purchase pensions capped at £10,000.
We’ve seen gilt yields fall in recent weeks although annuity rates have held up pretty well and marginally increased in some cases. The recent market falls will push back expectations for interest rate rises and this is likely to have a negative impact on annuity rates going forward. Those buying an annuity should always shop around and check to see whether they are entitled to enhanced terms.
Full explanation of graph and case study scenario
A healthy non-smoking man takes his tax-free cash and goes into drawdown on his 65th birthday. He has £250,000 invested.
• Each year, he chooses to draw an income equivalent to the annuity his remaining drawdown fund could buy at that point. In the first three years his fund value falls by over 50%. It then makes a modest recovery, before falling again, but by then the damage has been done.
• On day one, the annuity income available is £14,947, paid for life. At the end of ten years, the annuity his fund could buy is just £8,196 per annum.
Summary: High withdrawals are not sustainable in drawdown and are made worse by poor investment performance. If this client had decided to take the full £14,947 each year, his fund value (on which he relies for a lifetime income) would have diminished by almost 80% to £53,331 in the first 10 years. High withdrawals will significantly impair the ability of the portfolio to recover from the market’s inevitable falls.
This case study is designed to show you the risks of drawdown. Of course, get it right and there is the potential for increasing the income and the fund value over time, but the important point is there are no guarantees.
The annuity incomes quoted are for a healthy non-smoker, paying a level income with no death benefits, annually in arrears. The chart assumes annuity rates as at March 2015 for his age and fund value at that point: in reality annuity rates fluctuate and could go up and down in future.