Many of us who have retired in the last ten years or so and are taking an income from our pensions will be waking up this morning and facing the prospect of a catastrophic hit to our future prosperity as a result of the market crash.
The situation will be particularly acute and troubling for those who have taken advantage of the Government’s relaxing of the pension rules since April to start drawing a regular income from their pension pots.
Why is the Market Crash so Devastating to new Pensioners?
One of the most serious, yet least well reported risks in the early stages of pension drawdown is that of ‘Sequencing Risk’ – the dangerous impact on your investments and long term prosperity 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 adviser and marketing 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 ‘straight line’ assumption.
This is the idealistic (but seldom realistic) smoothed investment growth curve of the ‘Your Plans’ diagram. However, life is seldom a straight line and we are at the mercy of the unpredictable path that markets have a habit of springing on us. In this case, the ‘The Universe’s Plans for You’ diagram is the more likely.
Taking regular and identical withdrawals in times of market weakness such as that depicted by the diagram can be catastrophic – destroying the health of your pension pot and causing you to run out of money much sooner than you might have planned.
Sequencing Risk works like this – 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. This chart shows how damaging such a course of action can be to the number of years your pension will last.
Option 1 (but not really an option at all) – Don’t do Nothing
The first and most important thing is not to do nothing. A crash such as that which has been happening to the markets over the past few weeks demands your attention. Even if you later decide not to take any action it should be because you have reviewed your options carefully and made a conscious decision not to do so. Unfortunately, we are all subject to psychological influences that leave us unprotected in certain investment situations. We cover many of the psychological risks of investing in our Risks and Psychology of Investing section but a concept known as Situational Blindness is particularly damaging in times of market weakness. In Situational Blindness people have a tendency to just shut out the prevailing market realities in order to do nothing – postponing the evil day when the losses just have to be confronted. If you know that the underlying value of your pension pot has just been dramatically reduced in the crash, yet you read everything in the newspaper apart from the financial pages, and choose not to check the diminishing value of your pension pot, you are probably suffering from this blindness effect. I know that I suffer from this one – I check the perfomance of my portfolio daily when markets are rising but I let the daily check slip when markets are heading down or have suffered a correction – just the time I should be checking and taking any remedial action necessary.
So – recognise the psychological state you might be experiencing and resolve not to be affected by it – review your situation in the next few weeks when the markets seem to have reached their lowest point and decide on a course of action.
Option 2 – Access your ‘rainy day’ cash reserves
If you received advice from a financial adviser before you started drawdown, or had the good sense or the spare funds to do so, they will almost certainly have advised you to retain a cash reserve in the event of a rainy day. Well, the torrential downpours in the south of England yesterday heralded just that – a very rainy day for your investments! If you have the luxury to do so, now is the time to consider making use of that reserve to fund your monthly income from cash and not from your pension. This allows you to postpone withdrawals from the pension until market conditions improve, and avoid the impact of the Sequencing Risk mentioned above.
Option 3 – Withdraw just the ‘Natural Yield’
Withdrawing just the income generated by the underlying investments is known as taking the ‘natural yield’. This leaves the underlying investments intact, improving the prospects for capital growth and a rising income over time, although as we all know both capital and income can fall as well as rise. There are a number of ways to generate a regular income within a drawdown account: for instance dividends from shares, or income paid by bonds. You could of course buy the shares or bonds directly but the safer approach unless you are a skilled investor is probably to use an experienced fund manager to make the decisions for you by buying into those income funds that have the principal objective of delivering a regular income.
Option 4 – Reduce the Size of your Monthly Withdrawals
When setting up your drawdown you will probably have approached it by deciding initially what level of income you needed each month to meet your outgoings. If you estimated on the conservative side and now find you have a small surplus at the end of each month, now might be a good time to consider reducing the level of withdrawals, at least temporarily until the markets recover.
Option 5 – Reduce the Volatility of your Investments
Unfortunately, this Opton is all about hindsight, and is not really something to consider until the markets recover. However, not everyone appreciates that financial markets regularly suffer suffer large corrections (or it may be just poor or selective memory that prevents us from taking these into account). 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 in every 2 years, lasting an average of 216 days before regaining their previous level! Consciously reducing the volatility of your investments through diversification and careful fund selection can reduce the impact of major market corrections, but as we have seen recently, when the markets are in freefall pretty much everything heads south.
Over to You
If you have any other ideas or techniques for protecting your pension pot during market crashes, or you would just like to share your thoughts, do please make a comment below. We will be revisiting this topic when the markets have started on their recovery, so do please sign up to the Newsletter for regular updates and thoughts on how best to manage your Pension.
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