The most overwhelming risk with income drawdown is running out of money before your time is up. Drawdown was only usually considered a viable option for those who could afford considerable fluctuations within their funds. However, now it’s the default option for retirees.
One of the biggest fears is something called sequencing risk or ‘pound cost ravaging’. This is a result of early losses within the fund doing irreplaceable damage to the overall portfolio and strategy for sustainable income.
If a portfolio declines 10% and 5% income is taken during a year, it will need to grow by around 17.65% the following year to get back to the same position. It will need to grow by even more if income was taken in year two.
Take £100,000 declining 10%, which leaves £90,000 and then take 5% of the original value (£5,000). This leaves a fund of £85,000.
If the income needed was £5,000 a year (5% of the original value), any early losses means the fund would have to work a lot harder after these decline to be sustainable.
The perfect scenario is a fund which grows by 5% a year and the growth is just skimmed off the top, leaving the fund value constant.
So £100,000 grows 5% to £105,000, and 5% (£5,000) is taken. Meaning a capital value of £100,000 is left.
Unfortunately, markets don’t behave and right now, still within our first year of the mass take-up of drawdown, they’re being very naughty.
Markets are down 11.71% today, since the new tax year began on the 6th April.
What this means is that people who need to take an income at the above percentages, may have an issue with the longevity of their portfolio.
If the markets continued to decline for a second or third year at the same rate, it may force an earlier take up of equity release as an additional form of income.
Taking an income in declining markets locks in losses. It doesn’t give that part of the fund time to recover. The result is a fund which diminishes a lot quick than forecast.
So what can you do to prevent this?
There are various schools of thought and strategies to limit this effect.
The 4% withdrawal rule is one commonly considered approach. Used largely in the US where people similarly keep their pension invested in retirement, it stated that you have an 80% to 90% chance that your savings will last 30 years. You simply withdraw 4% in the first year and then subsequently increase this by inflation to keep its real spending power.
This really depends on having a good diversifications of investments within your portfolio. Stocks, bonds, cash and property. Over exposure to less risky assets such as cash won’t provide it with enough ability to grow and over exposure to stocks might reduce its value significantly in highly volatile markets.
Another key consideration is life expectancy. How long will you need the money to last? This is the $64,000 question. A clever way is to use annuity companies to help you.
Annuities are based on medical history and the insurance companies are pretty accurate at assessing risk. They will determine, based on your health, medication and past ailments, how long they will have to pay you before they make a profit.
You could therefore request a number of annuity quotes to determine what break-even point is. How long will an annuity company pay you before they have paid out more than you put in. Obviously they will factor in the growth you receive on your money but it’s a useful, if not sobering tool to use.
Others suggest keeping some of your drawdown fund in cash. This can be used instead of selling investments within your fund when markets are declining. It could then be replenished in rising markets after some growth is achieved.
A sensible, if not always practical route, is to only take the income generated by the investment, this is known as the natural yield. This would leave the underlying investment intact giving it more chance to provide the realistic growth you expect.
There are many options to consider and they won’t be suitable for everyone.
What we do know is that right now, those who have entered drawdown haven’t got off to a good start. If investment risk is something that’s new to you or your nervous of the effects it could have on your fund, there are other more secure options.
If in doubt discuss these with a financial adviser.