Drawdown is attractive because your pension benefits from stock market growth throughout your retirement. However, it also exposes you to the risk of a major correction like the one we have just seen. This is particularly dangerous as pensioners have less time to wait for markets to recover and recoup their capital losses.
Hundreds of thousands of people have opted for drawdown since pension freedom reforms were introduced in April 2015, and some will have shredded nerves after last week’s market volatility. Is drawdown the right option for you?
Pension freedom reforms put an end to the obligation to buy an annuity, an income for life, at retirement.
Sales instantly slumped as many people had become disillusioned with restrictive annuities, especially after interest rates plunged in the wake of the financial crisis.
Every three months around 200,000 over 55s take advantage of the freedom to draw cash from their pension pots and Tim Holmes, managing director at financial adviser Salisbury House Wealth, said most have been sensible: “There has not been the tsunami of withdrawals that many worried about.”
However, he warned that people must avoid drawing too much, especially when relatively young, as they could deplete their pot and run out of money in later life.
income crash Traditionally, only savers with large pensions used income drawdown, but those with smaller pots are now doing so, and they are particularly vulnerable when markets crash.
Tom Selby, senior analyst at broker AJ Bell, said tumbling stock markets can be a nightmare for drawdown investors: “One or two years of poor performance at the start of retirement could inflict major damage on your pot that can be difficult to make up later.”
It can be doubly difficult if you are simultaneously dipping into your capital to fund daily living expenses, as you risk being forced to draw funds at the bottom of the market, crystallising your losses. “Drawdown works better if you can live off the dividends and interest payments that your investments produce, and leave your capital to recover,” he added.
Stock markets have performed strongly since the new freedoms were granted, but last week many pensioners got a taste of how life could be when markets struggle.
Selby advised checking your portfolio to make sure years of rising markets have not lured you into a false sense of security: “Confirm that your portfolio matches your appetite for risk, can still produce enough retirement income, and will last as long as you do.”
There is no need to panic at the moment. “Current fluctuations are short-term in the extreme, so do not make any rash decisions based on a few days of volatility,” he added.
None of this is an issue with annuities, as once you lock into a contract they pay guaranteed income for life, no matter how long you live, or what happens to stock markets.
MIX AND MATCH
Andrew Tully, pensions technical director at Retirement Advantage, said it is wise to hold a couple of years worth of income in cash to cover essential spending: “That way you can ride out the storm and wait for markets to start climbing again.”
If you have no cash cushion, now may be the time to review your portfolio and consider reducing your exposure.
The choice between income drawdown and an annuity does not have to be all or nothing, in fact, a blend of the two could be ideal. Tully added: “If you want to take some risk off the table then consider using part of your pot to buy an annuity, to secure a guaranteed income to pay for essential expenditure, and leave the rest invested through drawdown. That strategy should give you breathing space when markets take a wobble, and avoid the need to sell in a falling market to generate income, which can have a devastating impact on your portfolio.”
RISK AND RETURN
Hargreaves Lansdown senior analyst Laith Khalaf said anybody tempted by drawdown must accept that they will be exposed to the ups and downs of the stock market: “Your retirement will be no fun if you spend half your time fretting over share price movements to see whether you can afford to go shopping today.”
Even those who can withstand a little market volatility should ensure they have a diversified portfolio. “Spread your money across bonds, cash and property funds rather than putting it all into stocks and shares, to limit the impact of a market crash,” he added.
Last week’s market swings do not spell the death of drawdown, but you need to make sure it is the right strategy, as the nine-year bull market run draws to a close.
Patrick Connolly, certified financial planner at Chase de Vere, said there is also danger in having too little stock market exposure: “Some people will spend 30 years or more in retirement and if they leave all their money in cash and bonds its value is likely to be eroded in real terms.”
Annuities are the only thing that can provide financial certainty in retirement. As interest rates recover, they could just swing back into favour.
‘Drawdown works better if you can live off the dividends that your investments produce’
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