Earlier this week, we reported that this year's average pension fund performance could end up in negative numbers. For those who aren't sure what this could mean for their own pension, we've asked Moneyfacts Head of Pensions Richard Eagling to clear up some confusion around this difficult topic.
The importance of a sustainable income
With people living longer and inflation still reducing the value of our wallets, it's important for anyone nearing retirement to make sure they have enough stashed away to last, no matter what happens to their health or the economy. Key to this is ensuring a sustainable retirement income, as this will likely be the only income – aside from the State Pension – that most people will have to rely on after they stop working.
"Pension value falls in the early days of taking an income can have a devastating impact on retirement income sustainability," Richard explained. "As a result, it is absolutely crucial that investors have some understanding of these risks or have access to an adviser who can monitor these risks and provide the necessary help and support."
Since the pension freedoms, people over 55 can access their pension funds and take out as much as they like, with the first 25% taken as a lump sum being tax-free. Without proper advice, someone might be tempted to withdraw their entire pension fund at the first sign of negative returns. However, putting these funds in a regular savings account would likely result in a much larger loss of interest, not to mention a potentially hefty tax bill.
To drawdown or not to drawdown?
That said, withdrawing money from your pension in a measured, controlled manner – through drawdown – is one of the two main types of ways to get pension income (annuities being the other one, although providers are now coming out with hybrid solutions as well). In simple terms, drawdown allows retirees to take an income from their pension while leaving the rest invested to keep gaining interest.
"When retirees begin withdrawing money from their pension, the sequence of investment returns can be crucial to the prospects of providing a decent long-term income," said Richard. "Research from Zurich earlier this year suggested that a third of retirees relying on drawdown are first-time investors. This is incredibly frightening, particularly as many do not use financial advisers. To expect individuals with no stock market experience to be able to manage their own, very often inadequate pension pots and take a realistic income for an indeterminate length of retirement is highly optimistic, to say the least."
In contrast, using your pension pot to get an annuity would result in a set income for the rest of your life – however long that may be. Despite this, due to annuity income often falling below the potential income that could be gained through drawdown (depending on all manner of personal circumstances such as the size of the pot and the pension funds people are invested in – again we can't stress enough the value of seeking personalised professional advice), drawdown is currently the more popular option.
Safeguarding pension funds during drawdown
If you're willing to take the risks of drawdown, Richard has suggested some steps "that investors can take to help safeguard themselves against market falls impacting their drawdown strategies":
- "The first step is to seek expert financial advice and use an adviser to review and monitor your drawdown pot to ensure that your drawdown income is sustainable. It is almost inevitable that at some stage drawdown investors may have to adjust the income they are taking to reflect the rate at which their underlying pension pot is growing or not growing. These are big decisions and calls to make; getting it wrong could be devastating.
- "Other ways to negate some of the impact of stock market falls on drawdown funds would be to keep a diversified portfolio of funds spread across different asset classes and sectors. Hopefully if one asset class or sector is underperforming another asset class will still be holding up okay. Keeping all of the drawdown pot in one fund or asset class could prove very risky.
- "Another solution to investment losses would be to adjust the amount of income being taken, and if possible cease taking an income altogether until markets recover. How realistic this is will depend upon what other sources of income an individual has to fall back on.
- "Finally, there is also the option of limiting withdrawals to just the natural income produced from share dividends or bonds so that as much of the original capital remains untouched until the market recovers. This concept of harvesting the natural yield is one that some individuals pursue."
