Pension survival: in the worst case, your pot could fall 60pc in 15 years (original) (raw)

23 September 2016 8:21am BST

Most savers gave a warm welcome to “pensions freedom”, which ended the effective compulsion to guarantee an income for life in retirement by buying an annuity. These savers do, however, face a significant new risk: running out of money if they spend their retirement funds too quickly.

What they need to know is how much can safely be withdrawn from their savings each year – the “safe rate of withdrawal”.

To find the answer, assumptions must be made about two key unknowns: the future rate of return from the portfolio and your life expectancy.

A good starting point is the respected Barclays Equity Gilt Study, which details returns back to 1890. It tells us that the average “real” return (i.e., after allowing for inflation) of a portfolio split equally between British shares and gilts (British government bonds) has been 3.1pc a year over this period of 135 years.

Turning to life expectancy, official mortality records suggest that 65-year-old women should reach 90 on average, implying an investment term of 25 years. Using the assumptions above, this woman could withdraw up to 6pc from her portfolio in the first year and then increase withdrawals in line with inflation for the rest of her life, with the capital exhausted just after death.

John Spiers

John Spiers says that while past returns can provide a guide, we are not in normal times

That sounds pretty encouraging but sadly the real world is not so simple. Although real investment returns have averaged 3.1pc a year over the past 125 years, over 20-year periods they have varied from -2.7pc to +9.8pc.

All we can say with certainty about the future is that the latter figure will not be matched because gilt yields – a benchmark for the financial markets – are now at historic lows.

Our 65-year-old woman is predicted to live to 90. However, she might be unlucky enough to die just one day after her 65th birthday but also has a one-in-four chance of reaching 95. In fact, the odds are probably higher than that because rich people live longer than the poor and life expectancy has been rising by about a year every decade.

Changing the investment return assumption to -2.7pc a year and life expectancy to 30 years reduces the maximum withdrawal rate to 2.2pc, with the value of the fund falling by 60pc after 15 years. Hardly a comfortable prospect.

And that’s not all: investment returns will not be even, but volatile from year to year. When you withdraw money from a portfolio you are vulnerable to “pound cost ravaging”, the opposite of “pound cost averaging”, a known bonus for regular savers. The essence is that when prices are low you have to sell more units to get the same amount of cash.

As a result of all these factors, I don’t believe there is a safe fixed rate of withdrawal. Does that mean that everyone should buy an annuity?

Definitely not. An annuity may be the only way to insure against the risk of living longer than average but right now could be the worst time in history to buy one. Bond yields are at record lows, which has a direct negative impact on annuity terms.

In addition, an unintended consequence of pensions freedom has been that many people with low life expectancy who were previously forced to buy annuities no longer need to do so. With less of a windfall from annuity-holders who die early, insurance companies have had to lower their rates even further.

I reckon it’s probably better at the moment to keep a pool of cash on one side to maintain flexibility and then review the situation regularly. How about just withdrawing income, leaving your capital intact?

A typical UK equity income fund currently yields about 4pc. Dividends usually rise at least in line with inflation, so surely that’s a better solution than playing roulette with your capital, or buying an annuity while gilt yields are at rock bottom?

It probably is but there are no guarantees. Go back to the Thirties and dividends from British shares more than halved within six years. If you were totally reliant on that income, that would be a problem.

The optimal course of action will depend on your individual circumstances and preferences, but there are a few general guidelines that I’d recommend.

First, split your expenditure into two groups. The first covers core essentials and emergencies: include all items that are needed to have a moderately comfortable lifestyle.

Take steps to ensure that you will have enough income and capital to cover these costs in all circumstances plus enough liquid cash to cover 12 months’ spending.

The second group is discretionary spending: on holidays, asset purchases, etc. Be prepared to be flexible with these so you can reduce spending during tough times and minimise the impact of pound cost ravaging.

Most people find that these costs are higher in the earlier years of retirement but then tail off until the cost of care becomes a factor.

Next, take a look at all of your assets, including your home. There are several ways in which you can extract part of the capital value of a property while still being able to live there. While there are some disadvantages to this approach, it can be helpful from an inheritance tax perspective to maintain value in a pension fund rather than in a property.

Finally, take care in setting your investment policy. You will need to be thinking about the long term and that suggests a high weighting to assets that provide some protection against inflation, such as shares and property.

However, this will result in significant fluctuations in the portfolio value. It is absolutely essential that you don’t panic when markets are going through a period of turbulence, so make sure that you understand what a bad year might look like.

Don’t forget, though, that the main objective is to enjoy retirement, so strike a balance between frugality and fun.

John Spiers is the chief executive of EQ Investors, and was founder of Bestinvest.

Starting pension fund value: This is the total size of your pension pot at the point you wish to start drawing down an income.

Target annual pensions income: This is the amount, pre-tax, that you want to take as income from your pension.

At what age it is due to start: The age you will be when you take the lump sum and start to take income from the pension – this could be before your formally retire depending on your situation.

One-off withdrawal: The size of the initial lump sum you want to take out. Normally, up to 25pc is able to be taken tax-free. The calculator won’t apply tax for amounts larger than this to be entered.

Annual investment return: The return after fees and inflation that you expect your pot to earn annually. Reasonably you could take off 1pc to 1.5pc for management fees depending on whether you are managing the money yourself or having it done for you. Plus if you want to plan for inflation you need to deduct the current RPI rate.

Specialist pension advisers Tideway Wealth, who have provided the calculations, currently recommend using a projection rate of 2pc net of fees and inflation, equivalent to a gross investment return of about 4.5pc per year for a relatively cautious managed pension investment fund.

The two lines displayed on the graph are the progress of your pension pot with and without taking the initial lump sum amount. Where a line hits the bottom of the graph, that is the point at which the pot would run out.

You can see the original calculator created by Tideway Wealth here, and their own guide on how to use it and the assumptions made in the calculations here.