Financial Times: Don’t let your pension run out of money

By Moira ONeill

Making flexible withdrawals from your pension pot — or drawdown — remains the most popular retirement income option, according to new data from the Financial Conduct Authority. But after a splendid run for the stock market in the first three months of the year, could drawdown investors face risks that they barely recognise?

Given the substantial improvements in annuity rates since the start of 2021, analysts had been expecting the regulator to report a continuation in the surge in annuity sales reported the year before. Legal & General’s latest standard annuity rate is 6.45 per cent, 30 per cent higher than it was in April 2022.

But annuity sales fell by a shock 14 per cent. The number of drawdowns, by contrast, increased 6 per cent, with more than 218,000 new policies signed up.

There’s nothing wrong with choosing retirement income flexibility over a guaranteed set income for life. But drawdown investors need to tread carefully.

By far the most common withdrawal rate in drawdown among pension pots worth up to £250,000 was “greater or equal to 8 per cent”, with more than 191,000 people (two-fifths) taking withdrawals of this size from their retirement pots.

This is far higher than historical rules of thumb. To be confident their pension money will last through retirement, a saver has conventionally been told to limit withdrawals to 3-4 per cent of the value of the fund each year. 

Meanwhile, another issue — and arguably drawdown’s biggest risk — relates to the investments that you hold. A “sensible” strategy for drawdown investors is to hold a fair proportion of investments in equities. After all, you have 20 or perhaps 30 years in retirement, which means you need your pot to keep growing.

The Office for National Statistics’ National Life tables show that for those aged 65 between 2020 and 2022, men could expect to live another 18.3 years, and women another 20.8 years. For more scary (but probably less scientific) results you could use the website death-clock.org, which told me I’ll live to be 92.

Equity exposure can protect against inflation, something that may be at the forefront of your mind after this week’s news that UK inflation had fallen less than expected. Inflation at 3 per cent will reduce the buying power of £100,000 to £74,000 over 10 years, according to the inflation calculator at Wesleyan.

When you’re accumulating (building your pension pot) you can “buy and forget”. Plus, regular monthly accumulators may have been comforted by “pound-cost averaging”. This is based on the principle that when markets are low, you acquire more for your money, and when markets are high, you acquire less.

But when you’re decumulating (drawing an income), you need to “draw and inspect”. The inspection is a regular check on global stock market indices.

If history is a guide, over a period of 20 to 30 years, expect a couple of big stock market crashes, plus a few smaller crashes in between. Maybe a 20 per cent correction in equities every 4-5 years on average.

“So what?” those who have bought and forgot may say. “We have those 20-30 years to weather the crashes.”

But investors taking regular withdrawals face pound cost averaging’s evil twin: drawdown sequencing risk. Drawdown funds provided by insurers and platforms, or model portfolios from wealth managers, are all vulnerable to this because they hold a mix of equities and bonds.

The problem comes in how these investments are accessed to fund the monthly withdrawal. If the drawdown fund or portfolio sells across both of the investment classes every month, you’re always selling equities and bonds to make the income payments. This means you’ll become a forced seller of equities in a stock market downturn. Selling investments at lower and lower prices can do irreparable damage to the account value.

There are a few strategies that advisers use to reduce drawdown sequencing risk.

One is only taking the “natural income” to avoid drawing on the capital. This means only the bond, dividend or rental income generated by the fund or portfolio is available for withdrawal. It could lead to variable income and is probably only a strategy that those with the means or inclination to keep the capital can use.

Using a cash fund to pay income in the short term, say two to five years, could help too. There are now some decent rates on offer, such as Investec, which pays monthly interest of 5.25 per cent on a minimum investment of £5,000

Another solution is a dual drawdown account. The longer-term account has a mix of equities and bonds, with income and profits from that account taken into a shorter-term account. The shorter-term account contains say five years worth of income, invested in short-dated bonds that aren’t affected by interest rate changes.

If the market turns down you could suspend profit-taking from the long-term account and wait five years for a recovery in prices before topping up the short-term account.

Tideway, a wealth manager which uses this method, estimates that on a £500,000 drawdown portfolio over 25 years, factoring in a few stock market downturns, a dual drawdown account could give a 66 per cent uplift in returns vs withdrawing from a typical balanced portfolio. It would also keep the £500,000 capital largely intact, while the balanced portfolio would see it depleted.

Not everyone entering drawdown is well informed. No regulated advice or guidance was sought for 37 per cent of income drawdown plans taken out in 2022-23

The dangers of sequencing risk are particularly acute if a big market downturn occurs in the years immediately after retirement, when the portfolio value is typically at its highest and there are many years of retirement remaining. This means drawdown’s biggest risk could be about to get scarily real for the 218,000 new policies entered into last year.

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