When markets fall clients can suffer the triple impact of:
- the falling capital value of the fund;
- further depletion due to the income they are taking out, and;
- a drop in future income.
This is especially dangerous at the start of retirement because, if they are not careful, investors can rack up big losses that they are never able to make up again.
Let us look more closely at how negative pound cost averaging can impact retirement pots.
The table below from Quilter illustrates how pound cost ravaging can take a severe toll if there is a market upset at the outset of income drawdown in retirement.
| Table 1 | Portfolio One | Portfolio Two | |||
| Year | Withdrawal | Annual returns | Annual Portfolio (£) | Annual Returns | Annual Portfolio (£) |
| 0 | £100,000 | £100,000 | |||
| 1 | £5,000 | 30% | £125,000 | -20% | £75,000 |
| 2 | £5,000 | 20% | £145,000 | -15% | £58,750 |
| 3 | £5,000 | 5% | £147,250 | 5% | £56,688 |
| 4 | £5,000 | -15% | £120,163 | 20% | £63,025 |
| 5 | £5,000 | -20% | £91,130 | 30% | £75,933 |
| Cumulative Return | 11% | 11% | |||
| 18 per cent difference in year 5 portfolio value | |||||
Source: Quilter Investors. For illustration purposes only
In the first portfolio, returns are strong to start off with then turn negative later in a five-year period, and in the second they are negative right at the start and then recover.
The cumulative return figure is the same over five years, but the portfolio value is much lower in the latter scenario. As you can see there is a significant difference in the value of the portfolio, purely based on the timing of withdrawals and when annual returns were negative or positive.
Protecting pension investments in a bear market
Depending on your client’s personal circumstances, financial means, attitude to risk and capacity for loss, the strategies you could consider include:
- Review the levels of income being taken through drawdown: undertake a detailed expenditure analysis and see if the level of withdrawals can be reduced or even stopped.
- Use cash first: if the client has sufficient cash deposits, persuade them to use these before making withdrawals from invested assets.
- Only take ‘natural income’ from investments: this means withdrawing only money generated from dividends in shares or funds of shares, or 'coupons' (the interest) from bonds.
- Review the pension portfolio: keep the portfolio, goals and attitude to risk under review and think about which funds to make withdrawals from to minimise the impact of ‘pound cost ravaging’.
- Delay retirement plans: if your client has not yet retired or not fully retired you should talk to them about the possibility of delaying retirement until markets settle.
- Alternatives to drawdown: can you meet the client's needs with annuities, or fixed-term annuities? You might look at buying annuities in tranches – again as part of a review – because annuity rates are rising.
It may also be a good time to buy into markets. It may sound counterintuitive but this could be an opportune moment to invest into the market for a period of 12 to 18 months and might help mitigate the potential impact of a fluctuating and bear market.
However this option is only suitable for some clients, that is, those who:
- are more experienced;
- have the capacity for loss;
- have other significant assets;
- can withstand the short-term losses, and;
- are looking to invest in the longer term.
Of course, if a client does choose to go down this route, you will have to make sure you explain the risks involved and ensure that they have understood what they are undertaking.
Richard Cooper is business development manager at the London Institute of Banking & Finance
