PENSION investors relying on drawdown funds for their income in retirement could see their savings eroded at a frightening rate in the event of a downturn, advisers have warned in the wake of recent volatility.
The risk of shunning the security of annuities in favour of flexi-access drawdown, where the pension pot remains invested and income is taken directly from it, have been highlighted by last month’s stock market turbulence.
Some £1.1bn of income-drawdown payments were made by members of the Association of British Insurers (ABI) in the three months after the new rules were introduced, as annuity sales slumped.
But pension providers and advisers reported a marked increase in calls from worried drawdown investors when stock markets were rocked by volatility in China. While drawdown offers greater flexibility than annuities, recent events have served as a timely reminder of how market downturns can affect the value of investments and the amount of income people can take from them.
The impact is exacerbated by “pound-cost ravaging”. This is a twist on the better known concept of “pound cost averaging”, where people who invest regularly buy more units in their investments when prices are low and so benefit when they rise.
Pound-cost ravaging, where money is taken from investments in falling markets, is an altogether more damaging affliction that drawdown investors must be aware of, said Richard Leeson, Edinburgh-based wealth management expert and consultant.
“You can suffer from pound-cost ravaging when you withdraw money from an investment on a regular basis, such as in pension drawdown,” he explained. “It occurs when you withdraw a fixed amount regularly and the markets fall, as they have this year. Advisers woke up to pound-cost ravaging in the aftermath of the 2008 crash.”
Say you started the year with a drawdown fund of £100,000, from which you want to take 4 per cent a year (£4,000). The market has fallen by just over 7 per cent since the start of this year, reducing the value of the pot to £93,000. Factor in this year’s withdrawal for income payments and you have £89,000, with next year’s withdrawal trimming it further to £85,000 and leaving you in need of a 17.5 per cent return on the investment to get it back to £100,000.
This is why most advisers recommend holding a certain amount in cash to protect the fund, particularly in the early years of drawdown.
The negative effects of pound-cost ravaging should not be underestimated, warned Jason Hemmings, partner at Cornerstone Asset Management in Edinburgh.
“A long-term, sustainable investment strategy should be high on the essentials list for flexi-access drawdown clients,” he said. “We only have to look at the volatility of the equity markets over the past month to highlight its significance.”
Many drawdown arrangements are still based on holding a single investment fund or a collection of investment funds, with a proportion sold each month to meet regular income needs. But that approach “is outdated and lacking in creativity”, said Hemmings.
“The biggest concern for us is people drawing a regular income from a single-risk rated fund or portfolio to supplement their lifestyle. This can have financial implications in times of falling or volatile markets and this is something that should be fundamental to retirement planning and the longer term sustainability of pension funds.”
Hemmings favours the use of separate portfolios where the regular withdrawals come from the elements that aren’t exposed to stock market volatility.
“Whilst this strategy is very important, so too is the need to review the pension portfolio and income withdrawal levels on a regular basis,” he said.
The need for a robust investment strategy in drawdown underlines the importance of seeking independent, professional finance advice. But there are concerns that many people taking advantage of increased pension flexibility are forgoing advice and instead entering drawdown through guided or execution-only services.
Edinburgh-based pension firms Standard Life and Scottish Widows have both reported a significant increase in the number of people entering non-advised drawdown, while fellow insurance giant Aviva has also added a non-advised drawdown service.
The risk of investors piling into drawdown oblivious to the potential pitfalls is heightened by widespread misconceptions over the option. Research published in July by the National Association of Pension Funds found that 70 per cent of people aged 55 to 70 but yet to access their pensions were attracted to the idea of drawdown. But more than half of those wrongly thought the income from drawdown was guaranteed and one in four believed it was risk-free.
Unadvised investors are more prone to taking too much income early on and draining their pension pot prematurely. They also lose recourse to the Financial Ombudsman Service and the Financial Services Compensation Scheme which cover regulated advice.
“Most of the people who are now exercising their pension freedoms will not have seen this volatility coming,” said Leeson. “Investors would be wise to consult a financial adviser before setting out on their own in a pension drawdown.”