Pensioners trapped by '˜drawdown captivity'

The change in tax rules was meant to liberate pensioners, not condemn them to a meagre income from bearish markets. Picture: Lou Oates

The latest bout of turbulence in global stock markets arrived in the wake of new pension rules that mean far more people are keeping their pension pots invested when they retire.

More than 43,000 drawdown plans were sold within six months of the April 2015 launch of the so-called pension freedoms, which allow people in defined contribution (DC) schemes to unlock their entire pension pot from the age of 55 without incurring punitive tax charges.

But the typical drawdown fund will have lost around 8 per cent in value since last April, according to Retirement Advantage (based on equity, bond and cash returns over that time). The losses will have been compounded by the income taken from those funds.

“This won’t be a great start to your retirement,” said Andrew Tully, pensions technical director at Retirement Advantage. “Losing around a tenth of your pot in 10 months will leave many people feeling queasy about the future.”

While there’s no reason to panic, he added, investors relying on their drawdown for their income “might well be spooked”.

“This may well push people into a period of ‘drawdown captivity’, rightly not wanting to crystallise losses, but needing to look at other options to pay the bills,” said Tully. “If you can afford to sit tight and ride out the rollercoaster, then great.”

The impact of taking income from a fund declining in value is referred to as “pound cost ravaging”. This is where the same level of income is taken from an investment even as its value declines.

Drawing income from a falling fund exacerbates the problem, said John Mortimer, head of financial planning at Shepherd & Wedderburn Financial.

“It can take much longer for the fund to recover, if at all. Make sure you have plenty in cash, either in or out of the drawdown fund, so that you can alter the source of some or all of your income.”

The key is to diversify, he added.

“Spreading the investments into different asset classes can reduce the volatility and therefore the adverse effects of a falling market whilst drawing income,” said Mortimer.

Yet many investors may be in riskier investments than they realise, particularly those who haven’t taken professional advice before entering drawdown. The Financial Conduct Authority (FCA) revealed last month that 42 per cent of people going into drawdown plans were doing so without taking regulated advice.

“I have seen a lot of people with pension funds that they think are low or medium risk and are in fact fully invested in the stock market,” said Mortimer. “The current market volatility means this can be a dangerous strategy.”

That stock market uncertainty might explain why demand for annuities has recovered slightly in recent months. Research by eValue found that the preference for the guaranteed income of annuities rose to 47 per cent in October, compared with 33 per cent in April, with the appeal of drawdown going in the opposite direction.

Annuities are “fighting back”, according to Graeme Mitchell, managing director of Borders IFA Lowland Financial Planning. Temporary annuities in particular are proving popular with people who don’t want to rely entirely on their drawdown funds for a regular income.

“You don’t have to withdraw more from the funds for a few years, so the investment has an opportunity to recover and replace what you used to buy the annuity,” he said.

“Alternatively you could buy a lifetime annuity and secure an income that you know will be there every month and unaffected by markets.”

Some annuities have 30-year terms which guarantee to repay your original capital, plus around 35 per cent over the term of the annuity.

“If you die it reverts (generally as a lump sum) to your next of kin. It’s a good rule of thumb to have a basic level of income to help you sleep at night,” said Mitchell.

You don’t have to choose between drawdown and annuities, however, as there’s no reason you can’t combine the two. While an annuity provides the guaranteed income and cover basic costs, drawdown allows for more investment growth and can be used to cover variable expenditure and inflation.

“People have traditionally been uncomfortable with the insurer receiving some of their pension pot on death from an annuity,” said Mortimer. “But why not consider it as an income ‘buffer’ – whatever happens in the markets, the traditional annuity will simply keep paying out.”

Don’t forget to shop around if you do buy an annuity, because you could get a much better deal than that offered by your existing pension provider. Yet almost two-thirds of people who bought an annuity between July and September 2015 failed to exercise their right to shop around, FCA figures show.

The regulator also found that almost seven in 10 savers holding pension policies containing valuable guaranteed annuity rates were not taking advantage of them.

Those making the wrong choices at retirement could pay a heavy price in the long run, Mortimer warned. “People often view their pension as a large sum of money, but someone retiring now and possibly living for 30 years could easily see that money disappear.”