How to sustain an income in retirement

What you’ll learn:

• What's a drawdown arrangement?
• What is ‘pound-cost ravaging’ and how it can impact your pension pot
• Which investment is well-suited to drawdown investing?

When you make that leap into retirement, there are a number of options available to you for generating the income you need from your pension pot(s). These options include staying invested, taking cash out (as a lump sum), buying an annuity or entering into drawdown.

Whichever option you take will come with its own risks. Poor investment returns from staying invested or simply taking a cash lump sum may not be suitable alternatives if inflation exceeds the returns on offer. While an annuity can provide peace of mind, inflation could erode its value considerably over time, unless it’s an index-linked annuity which ensures that your income increases each year in line with inflation, so that your spending power keeps pace with the cost of living. Drawdown may offer the benefit of flexibility, but it also comes with the significant risk of running out of income. Although drawdown today ranks as one of the most popular options among those reaching retirement age, it may not be suitable for everyone. Although this article is focused on drawdown, this isn’t a recommendation and the choices you make will depend on your personal circumstances.

The tax implications of staying invested in a pension as opposed to entering into drawdown are different. If you choose to hold your investments in a pension rather than drawing some money out and investing outside of a pension wrapper, you’ll accumulate returns that are largely free of tax. However, when money is withdrawn, it will be taxed as income at your marginal rate. This is an important consideration and you should seek advice from a tax specialist if you’re unsure about it.

More and more people are reaching retirement and entering into a drawdown arrangement. This allows retirees to keep their funds invested and take a regular income from them without committing to a lifetime annuity. While this option offers greater flexibility and the chance of a greater income, the price is more complexity and risk. If you decide to keep some or all of your pension invested, how can you ensure that you can get the income you need and that it won’t run out?

Is cash the answer?

People psychologically reduce all risks with age, both physically and mentally. The same applies to savings. As such, there’s a tendency for investors to anchor their funds to cash as a secure asset during retirement. However, cash isn’t without risk, although its nominal value will remain unchanged. The long-term effects of inflation can diminish the value of cash, especially in a low interest rate environment. Over the longer term (twenty or more years), US equities have always beaten cash¹, but there will be highs and lows along the way and there can be no guarantee that this will always happen – you can lose money in the long term and in the short term. Past performance is no indication of future returns.

Pound-cost ravaging

Good returns early in retirement can boost the amount of income you can take, but market falls early on tend to have the opposite effect. This is exacerbated by so-called ‘pound-cost ravaging’ (or ‘sequence risk’) – the effect of taking income from a fund as its value is eroded by market falls – which ‘locks in’ those falls and makes recovery harder.

Pound-cost ravaging happens most when you want to take a fixed amount from your assets. If you make a withdrawal straight after a market fall, you end up taking a bigger percentage of your assets and there is less left over to benefit from any market recovery. Taking a fixed percentage of your assets means this is less of a problem, but also means you could have big changes in the amount of income you get over time. Neither outcome is particularly attractive to the investor.

Retired people, where possible, should adjust the sums withdrawn annually to reflect how their portfolio has performed, (potentially) taking profits (or reducing risk) when markets are up and drawing less when they're down. However, remember that buying an annuity may be a more suitable option for you depending on your circumstances.

Challenges

The biggest challenge for drawdown investors is taking the income they need without risking the sustainability of their fund. If you want your pension savings to last, without knowing for exactly how long, you need to be realistic about the level of income you can draw. Ultimately, how much income you can safely take is determined by your individual circumstances.

Income units in a multi-asset fund (such as the our Ready-made Investment funds) can be well suited to drawdown investing. The funds aim to maintain capital growth and meet the income needs of investors, while mitigating the risks presented by short-term dips in the share market. They offer a one-stop-shop diversified solution by investing across different asset classes, regions, sectors and funds.

Regular check-ups

It’s critical to review all of your investments, including your pension, at least annually. This will help to ensure that the investments still reflect your risk appetite and objectives, and that your portfolio remains sufficiently diversified. A regular review will also help you make adjustments when your circumstances change which may have a bearing on the level of income you may need and the risks that you’re prepared to take.

Conclusion

Drawdown has become the most popular retirement income option under the pension freedoms² but whether anyone will benefit from it will depend on their individual circumstances, the uncertain future performance of investments and equally uncertain lifespans. With an average 30- to 40-year retirement horizon, people have the benefit of time to invest their assets in much the same way they did during the accumulation (working life) phase. In fact, the accumulation period can be shorter than the drawing down period. Therefore, staying invested in retirement (when using drawdown) is one potential option which may deliver better returns and more money to enjoy (although this isn't guaranteed).

These are our current opinions but the future, as ever, is uncertain and outcomes may differ. Investments can fall in value as well rise; you may get back less than you invest.