Defending your savings in retirement

Danny Knight, head of investment directors at Quilter Investors, explains why adopting the same investment strategy in retirement as you did in accumulation can cause irreparable damage to your pension pot.

Many people spend their entire life building up a pension pot for retirement, looking forward to the day when they can stop work and start living off the proceeds. However, just as you have to adjust to a new life when you retire, your investment portfolio also needs to embrace a new normal.

In the accumulation phase of your retirement savings, the long span between starting to contribute to your pension pot and actually accessing it provides plenty of time to weather any unexpected falls or market movements that might reduce the value of your pot. For example, those invested at the height of the dot.com bubble in the early 2000s would have seen their pension funds fall, yet the recovery in markets over the next eight years helped smooth out those dips.

Equally, those who fell foul of the financial crisis in 2008 have had 10 years to recoup their losses, and thanks to the longest upward streak in US equity markets, many have probably grown their pension pots. Although, while US markets have performed well in the past decade, other global markets have had mixed fortunes with emerging markets falling out of favour and Europe, Japan and the UK struggling with domestic economic and political issues, making it important to choose your investments wisely.

Once you retire, however, the switch from being able to add to your retirement savings to stopping contributions and taking regular withdrawals means your pension pot is no longer able to bounce back as easily because you need the income sooner.

Sequence of returns risk

As a result, once you are in the decumulation or spending phase of your pension, any losses that occur early on in your retirement will be much harder, if not impossible, to recoup, compared to the accumulation phase.

The chart below can be used to illustrate how two funds can react differently in the accumulation and decumulation phase of investing. Fund A is a global equity fund and Fund B is a multi-asset fund with 50% equity exposure.

In the first chart, where someone might be investing for growth to fund their retirement they would most likely want to be in Fund A. From a starting position of £100,000 it ends 2017 at just over £450,000, while Fund B doesn’t do badly, but only grows to roughly £250,000 over the same period. In the second chart, using the same funds, the same period and the same starting amount, the only difference is that it accounts for annual withdrawals of around £5,000 each year, and increases the withdrawals year-onyear in line with inflation.

While Fund A did so well in an accumulation environment, in decumulation it never really recovered from the financial crisis and is depleted by February 2017. In contrast the multiasset fund, with its wider diversification does a much better job of conserving capital over the period despite the inflation-proofed withdrawals, with money still left in the pot long after the other fund has been exhausted.

For example, as table 1 shows, if in the accumulation phase your portfolio experiences a 25% gain, a 15% gain and then a couple of years of losses, this makes no difference to the end result than if you experienced the losses first and then the gains.

However, as table 2 shows, if you experience the same losses in retirement, when you are also withdrawing regular income, then the result is very different, resulting in a portfolio worth 22% less if you experienced investment losses in the first few years.

Inevitably, this means that Portfolio 2 will either be exhausted far sooner than Portfolio 1 or that it will be forced to substantially reduce the income it pays if it’s to avoid being eaten away – and that’s after just five years of what could be 30 or more years in retirement. This emphasises the destructive power of sequence of return risk and can lead to an awkward predicament if you start running out of capital and have to take an income holiday just at the time where you need income the most.

Taking steps to mitigate unnecessary risk Given the volatility that we have experienced in investment markets this year alone, as seen in the first three months of 2018 when concerns about economic growth, technology companies and President Trump’s trade tactics caused markets to fall, it is clear why this sequence of return risk needs to be managed.

Part of the solution is helping to defend your money against unexpected market falls or global events by sharing the risk across different asset classes. A broad mix of assets, such as equities, bonds, property, cash and even more alternative investments that have an in-built protection against inflation, such as infrastructure companies, helps the portfolio to offset losses in one area with gains in another to help create a smoother journey, evening out the dips and mitigating some of the harsher falls.

Embracing a new strategy The current economic environment is in something of a “Goldilocks” period, neither too hot or too cold, with strong growth and relatively low inflation, and until February this year, we have also had rosy investment markets that have set expectations high in terms of investment returns. However, there is no knowing when the upward streak in investment markets will end, as demonstrated by the sell-off in October, and when it does what the effects will be. It has been more than 30 years since Black Monday in 1987 and 10 years since the collapse of Lehman Brothers sparked a global financial crisis in 2008. It can be easy to forget these events and think the current investment environment will continue, but when entering retirement it makes sense to ensure you are prepared for all eventualities and are aware of the different risks that could lead to your pension pot coming to an end sooner than you might realise and taking the necessary steps to prevent it.

The value of investments and the income they produce can fall as well as rise. You may get back less than you invested.

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