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Pound-cost ravaging

15 April 2015

Retirees need to be aware of the dangers of drawing down a pension in a falling market.

‘Pound-cost averaging’ is a renowned strategy for long-term investing. The idea is simple: you invest equal amounts on a regular basis, no matter what markets are doing. The theory is that you are buying more of the market when it’s cheap and less when it’s expensive. It also provides a savings discipline and avoids the temptation to try to time the market. If you have regularly saved into a defined contribution pension plan, you have probably been pound-cost averaging for years.

Less well-known are the effects of ‘pound-cost ravaging’ – a phenomenon that occurs when money is withdrawn during stock market slumps. When capital is drawn from investments in a falling market, often to supplement income needs, funds erode more quickly because more shares have to be sold to achieve the required level of income. In these instances, severely reduced funds have little potential to bounce on any market recovery. As the name implies, pound-cost ravaging can rapidly deplete a fund and is a nightmarish scenario for people who don’t have alternative sources of income to allow them to put capital withdrawals on hold for any length of time.

Empty pot

This is all the more relevant as the UK’s over-55s embrace a brave new world of pension freedoms. In the new domain of pension liberalisation, people who would have otherwise bought annuities may be attracted to maintain control of their own pension fund. Pound-cost ravaging, therefore, has the potential to hit more of those who want to take income directly from their invested pension pot.

Greater freedoms do present greater opportunities, but keeping your retirement fund invested during the spending phase could mean there are greater risks too. To illustrate this, if someone invested £100,000 into the FTSE All-Share Index in 2000, and took a starting income of £6,000 a year rising by 2.5% each year, the pot would have halved in value by 2003 and would have run dry this year.1 It is true that stock markets over this period have been particularly turbulent; there have been two major corrections – first in 2001 and then in 2008 – but it’s a sobering thought for anyone taking a DIY approach to withdrawals in retirement.

Prudence pays

“People choosing to manage their own investments and take income at the same time need to keep close tabs on the value of the remaining pot and manage withdrawals accordingly,” warns Ian Price, divisional director at St. James’s Place.

“Take too much money in a year when investments have performed badly and the pot can be set on a course where it struggles to recover. A better strategy might be to take only the natural income generated from the underlying investments in the fund, which can help preserve the capital and mitigate some of the dangers.” adds Price.

Annuities, maligned by some, but which remove the need to manage investments and withdrawals altogether, simply pay out a guaranteed amount depending on various factors including age, health and, of course, the size of the investment.

To give an example, a 65-year-old single male retiring in good health today, with a pension pot of £100,000, could receive annuity payments of around £5,800 a year.2 Although this may appear expensive at first sight, the advantage is that income will never fall and payments will continue for his life, regardless of stock market fluctuations, or how long he lives. Alternatively, for many individuals, a combination of guaranteed annuity income and drawdown from their invested pension fund may provide the right levels of security and flexibility.

For those who decide annuities are not for them, one thing is clear: choosing an appropriate investment strategy and determining a sustainable level of income in retirement should never be made without the benefit of professional advice.

1 ‘When I’m Sixty-Four’, Cazalet Consulting, September 2014

2 Illustration of single life annuity, level payments, no guarantee;, March 2015

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

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