The Risks of Investing
The risks of investing are many and varied, and if you are the least bit interested, you will be aware of the many risks associated with the general practice of investing in the financial markets. As we enter retirement however and take advantage of the new freedoms to manage our own pension income drawdown there are some specific risks associated with that process which could derail your plans for a comfortable retirement. Of the options available, taking your entire pension pot in one go has pretty obvious risks which probably don’t need spelling out here (if you’re unsure of them the Money Advice Service has useful guidance). For the remainder of this article we shall assume that your plan is to carefully drawdown your pension pot to provide you with an income in retirement.
General Risks Whatever Option you Choose
Sequencing Risk or ‘Pound Cost Ravaging’
One of the most serious, yet least well reported risks is that of sequencing risk or ‘pound cost ravaging’ – the dangerous impact on your investments and long term prospects of a market downturn that happens just after you retire (or anytime in the first 10 years or so after retirement). Many of us assume, because the literature encourages us to do so, that if we predetermine a modest level of regular income withdrawal (4% seems to be the accepted reasonable withdrawal rate), we will be able to carry on indefinitely – and many of the pension calculators (including our own) and models used by advisers and pension providers make that assumption. However, taking regular withdrawals in times of market weakness can be catastrophic and can destroy the health of your pension pot, causing you to run out of money much sooner than you might have planned. This is how it works:
During a weak market, if you sell assets to maintain a set level of income, you have to sell them when they’re worth less. In other words, when the price of the shares or fund units you hold is lower, more of them need to be sold to provide you with the same amount of cash. Selling more units means weaker returns over time and reduced income from dividends or bond coupon payments, so more units have to be sold in the future to maintain the same level of income.
Put another way, the same dynamic that makes volatility good when you’re accumulating (the ability to take advantage of weak markets to buy more shares at low prices – known as pound cost averaging) makes volatility bad when you’re in drawdown – pound cost ravaging. Essentially, you’re selling more shares when prices are low and fewer when prices are high.
Time for a scary chart to clarify the concept:
In this example, both red and purple portfolios assume a 6% annualised growth rate. With the red portfoilo a weak market in the five years or so after retirement has a knock on effect that means you would run out of money at age 86. Compare this to the smoothed purple 6% curve you will find in pension planning illustrations, that implies you will have enough money left to pass on to your relatives!.
Another, more amusing look at why growth curves are never smooth in reality is shown here, courtesy of DogHouseDiaries. Take ‘Your Plans’ as the smoothed investment growth curve promised by the pension calculator, and ‘The Universe’s Plans for You’ as the more likely, unpredictable path that markets have a habit of springing on us. Putting the risk in perspective, the US markets (Yes, I know we’re in the UK, but that’s where the research is from) suffer a market decine of at least 15% once every 2 years, lasting an average of 216 days!
So, if we accept that this poses a significant risk to our prosperous retirements, what can we do about it? Well, forewarned is forearmed, so if you are going to retain an adviser to help you, raise this issue with them in your initial discussions, and certainly mention it when they start to show you some nice smooth growth curves!
If you can afford to do so, it makes sense to keep a pot of cash or quick access investments outside of your pension and postpone withdrawals from the pension until market conditions improve. However, this is a luxury that many of us will not be able to afford – if you are reliant on the income from your pension pot to cover regular expenses you may need to keep taking money out regardless of what’s happening in the markets. In this case a low volatility portfolio will help reduce the downside, but of course, at the expense of the potential upside.
Advisers don’t agree on Sequence Risk
Sequence risk has been a hot topic lately within the adviser industry, particularly given the market volatility of Summer 2015, and questions of post-retirement portfolio construction are at the forefront of advisers’ minds.
New research from CWC Research presented for the FE Investment Summit in September 2015 found that adviser attitudes towards sequence risk and its management within retirement portfolios vary widely across the industry.
The research, based on detailed interviews with advisers, found that while many believe sequence risk is an issue for their clients, not all agree. Within the CWC Research sample, one third of advisers hold no cash whatsoever to manage market volatility, while 40% recommend holding two years’ or more.
Within the responses, Clive Waller, Managing Director, CWC Research, found one adviser recommending seven years’ worth of income in cash or near cash for clients with a low attitude to risk, while another argued that holding a cash reserve reduces the return on the portfolio, making it harder to achieve the benchmark and the portfolio asset allocation, dictated by the client’s attitude to risk, is sufficient hedging of sequence risk. This glaring lack of consistency across the industry, with often widely opposing views, does little for the confidence of us consumers in advisers and in financial advice generally
- Michael Trudeau at Money Observer has written an easy to understand article about investing your pension in a bear market, with some scary but realistic examples.
- There is also a very good White Paper from Finalytic and sponsored by Aviva that addresses this in much greater detail. It is written for advisers not consumers however (so a little more technical), and you can read it here. You can also go on the Finalytic site and download it from there.
- The broader Adviser community has now also weighed in on the topic – while most accept the concept of sequence risk, much of the internal industry discussion is about what type of portfolios will protect you better – and here there is much debate and little agreement. If you want to investigate this from the Adviser perspective, have a look at Why Sequence Risk is Real and How to manage sequencing risk in a retirement portfolio from Professional Adviser. The counter position: Portfolio problems: the sequencing risk debate rages on is put by Paul Resnik in New Model Adviser.
- There is an interesting article at Moneyfacts.co.uk about the risks of drawdown and the other risks that have become apparent since the freedoms were introduced.
‘Lifestyling’ of Workplace Pensions is no longer appropriate
If you have been in receipt of a company pension your pension pot will probably contain a significant bias towards cash and longer-dated government bonds (it will have been ‘de-risked’ as you approach retirement as part of the ‘lifestyling’ approach adopted by pension firms). This is because, in the past, most people would have liquidated their pots at the point of retirement in order to purchase an annuity. However, with the new retirement pension freedoms, many people will now instead choose to keep their money invested and take income drawdown.
If you go for drawdown your pot will need to provide not only income but continued capital growth, so that it will keep generating an income throughout your retirement. The ‘de-risked’ portfolio you will inherit on retirement won’t deliver this. Not only does it have limited scope to provide capital growth, but in the current environment, it exposes savers to interest rate risk. Today’s low rates mean that a pickup in inflation could quickly erode the value of income streams from bonds, while if rates rise, bond prices will fall – meaning you will need to sell units to meet your income needs and will therefore lock in losses.
So – if you absolutely have to have a constant regular income from your pension, and you have no other funds available, the only real solution is to regularly review your portfolio and revise your plans if the growth is not all you expected it to be.
Traditional drawdown RISKS
This involves you designating all or part of your pension fund as Drawdown Funds, which will allow you to withdraw the money (or “draw down” the pot) as you see fit. You can still take up to 25% of the fund as a tax-free cash lump sum, with any additional withdrawals being used as taxable income. The rest of the fund will remain intact and will continue to be invested in your chosen pension funds. There are no limits on how much you can take as income.
Risk 1 – Running out of money
The average retirement is longer than most people think, so that need for income could be for over 30 years. If you don’t manage your income you could very easily run out of money from your pension pot, so it’s important to carefully plan your annual drawdowns to ensure you don’t spend it too soon. Exhausting your pot may be fine if you have income from other pensions or a full State Pension to fall back on, but if your pension pot is the basis for your main income in retirement, think carefully about taking too much too soon. Unlike with an annuity (see below), drawdown doesn’t guarantee you an income for life.
Risk 2 – Tax-free cash
In a traditional drawdown arrangement, you have to say at the outset how much of the fund you want to designate as drawdown funds, and crucially, how much you want to take as tax-free cash. If you don’t, you’ll lose the ability to take any cash tax-free, so you’ll end up paying more tax than you need for the rest of your retirement.
Risk 3 – Investment performance
The funds that you designate for drawdown are still invested in your chosen funds, so any downturn in investment markets can result in your fund value going down. This means careful selection about where your funds are invested will be needed. Most people in drawdown choose to move their funds into lower-risk areas to avoid large fluctuations in their value.
Taking regular payments direct from your pension fund
The Government calls these payments ‘Uncrystallised Fund Pension Lump Sums’ (UFPLS). Essentially, it means taking cash direct from your pension pot and using it like a bank account. The first 25% of each payment is tax-free, with the rest being taxable as income.
As well as the risks of running out of money and poor investment performance (as with drawdown), there are some other specific risks with this type of arrangement.
Risk 1 – Losing out on tax-free cash
As each payment includes a tax-free element, not all of the available tax-free cash can be accessed up front. Most people like to access the full amount of tax-free cash at the outset, either to spend or to supplement their other income in a tax-efficient manner, something that this arrangement doesn’t offer.
Risk 2 – Charges
However you choose to take your income, there will be some charges involved. Taking regular payments out of your fund is likely to be the most costly in terms of the fees and charges payable to the provider. These can eat into your retirement income, and could mean you run out of money sooner.