Beware the ravages of time!

Many of you will have heard of the concept of ’pound cost averaging’. The idea is that if you make regular investments into pensions or other investment accounts, you can benefit from market volatility by being able to purchase units at a lower cost when markets go down.

What investors, particularly pensioners, should also be aware of, is that the concept works in reverse. Often referred to as ‘pound cost ravaging’, it is when people begin to withdraw a regular amount from their investment portfolio which is more than the natural income that is otherwise generated. This is often the case with drawdown income taken from a self-invested personal pension (SIPP). If investment fund values drop, the withdrawals have much more of an impact on the overall value of the fund, thereby reducing the ability of the portfolio to recover during bounce-backs.

This point is particularly pertinent when trying to assess how much is a sustainable level of income to withdraw from a SIPP. 

One solution would be to draw the natural income from the funds held and not touch the capital. However, this strategy has its drawbacks. First, many high yielding funds, particularly those utilising fixed interest securities, tend to be  higher risk and therefore more volatile, and people are generally uncomfortable with the capital value of their retirement funds fluctuating too wildly. Secondly, you don’t receive anywhere near the normal level of income that a pension plan would produce if, for example, an annuity had been purchased, because of the requirement to retain all of the capital to maintain income levels. Lastly, income fluctuates throughout the year and does not usually get paid on a regular monthly basis, which makes income planning difficult.

A common solution is to use calculators to predict returns using broad assumptions on inflation and investment returns to find a level of income that will, in theory, be sustainable over the long term so that capital doesn’t run out. The advantage here is that you can increase the income received as you are drawing capital as well. The problem is that the assumptions used are linear, so you may assume a long term investment return of say 5% per annum (the mid-rate used by the FCA on pensions). Whilst this may be a realistic long-term assumption, there will be years where returns may be -10% or even -20%. During those years, you can either reduce the income you take, which often isn’t an option for most people, or you are forced into selling equities at a loss, thereby depleting the funds, and risking running out of capital over time.

Moore Stephens uses a far more structured approach to deal with the problem of assessing a sustainable level of income, using real world scenarios, which means that our clients have never been forced into selling equities at a loss.

We have designed a tool which uses real life historical data from the last 40 years to provide clients a more realistic picture of how sustainable income will be. So instead of plugging in a fixed investment return, the tool, runs thousands of scenarios using real life data to provide a more realistic indication of the portfolios prospects for surviving, based on drawing a particular level of income. This gives people far more comfort and confidence when selecting levels of income they withdraw from their pension or investment portfolios.

To add even more security, we notionally split the portfolio into two sections. The first holds money required for income in the next five years, consisting of safer, non-volatile assets such as cash and secure fixed interest holdings. The second holds money invested for the longer term which you can afford to take more risk with. You then draw income from the short term money and if markets go up, you replenish using growth from the long term money. However, should markets fall, the income can still be drawn from the short term secure monies, without having to sell any riskier assets at a loss. Once markets have recovered, the short term portfolio is replenished.

The strategy fits in well with our long-term, low-cost, structured, highly-diversified, evidence-based approach to investment.

If you have any questions we are happy to meet to discuss income strategies.

Leave a comment

 Security code

Paul Renken

Stephen, would love to see an article on 'unsuccessful wealth management' and how to handle it. IE, when a client has lost his pension fund, or forced into bankruptcy, or chronic health problems exhaust income and savings, or forced to liquidate assets at a loss.