The hidden danger of drawdown
Following the introduction of pension freedom in April 2015, annuity sales plummeted by more than 70% as pensioners have preferred to keep control of their capital and drawdown income as required. We worry that many have not fully understood the implications - it seems unlikely there has been an increase in the general population’s appetite for risk.
The risks of drawdown
Drawdown investors are faced with two major uncertainties:
- Timescale: a 65 year old female may have an actuarially predicted lifespan of 86.6 years but the reality will range from 65 to over 100.
- Investment risk: drawdown cannot work efficiently unless the portfolio has a significant weighting to risk assets. Therefore valuations will be volatile and as time goes by the ability of the fund to absorb losses will reduce.
The choice of whether or not to purchase an annuity or use income drawdown does not necessarily need to be an either/or decision; if your pension fund is large enough you might want to consider buying an annuity sufficient to cover your essential expenditure, whilst leave any remaining fund invested. This can then be used to provide a top up to income or remain invested to be passed on to family after your death.
The effect of pound cost ravaging
If you have set up a regular withdrawal from your pension fund it’s likely some units will be sold on a regular basis to provide your income. When markets fall, more units will need to be sold to provide your payments. But when markets recover, you have fewer units to benefit from the uplift. This is called ‘pound cost ravaging’.
The graph shows a pension fund of £100,000 with annual withdrawals of £5,000 increasing at 2.5% each year. The pink line assumes growth is steady at 5% each year and tells us the fund would be exhausted after 28 years.
The grey line assumes a slightly more volatile picture with the same total level of return but a setback of 3% for the first year and in year 17. In this case the fund runs out two years earlier. These figures are only provided for illustration purposes. In reality returns each year will vary and you are very unlikely to experience such smooth returns.
If the individual in the second scenario did not have additional resources to provide income, they could be significantly disadvantaged in later life.
If £100,000 was used to purchase an annuity with annual increases of 2.5%, the starting income would be £4,429 (including a 5 year guarantee period, but not a spouse’s pension). If you have a health condition, you could potentially benefit from a higher annuity rate.
It’s extremely important to ask yourself whether you’re happy with investment risk or have additional resources from which to cover your expenses. If you don’t, securing an annuity might mean a slightly lower initial income, but overall would be a more appropriate option.
Don’t put all your eggs in one basket
If you are following the income drawdown route there are steps that can be taken to remain on track and avoid the pitfalls discussed above.
If you can afford to do so, it makes sense to postpone withdrawals until market conditions improve. However, this is a luxury that is beyond the means of many.
For those reliant on the income from their pension pot to cover regular expenses, a diversified mix of investments will help protect against the effects of pound cost ravaging. When one part of the mix is doing badly, other parts may be doing well, meaning the timing of withdrawals is less significant. An annual review that includes cash flow modelling is extremely useful if you’re unsure about how much income you can expect from your investment plan.