Investment on the route down, what can go wrong!

We have said in previous blogs that investment risk when drawing down your money is a lot different than when building money up. Let’s explain why and what you can do about it.

Why is this?

When you are building up your pots some way off retirement, if the market falls, then to some extent who really cares? You can’t touch your money for some time anyway and you are making more contributions, which means you are buying in at a lower price.

That’s a lot different to when you are nearing retirement or, actually in retirement. At that point you are likely to be taking your money soon, or already do so to live off. Hopefully using a plan we have helped you build!

What matters if I am already taking money?

Every time you take some income that is the end value of that money. What you get is what you get. In techy terms, you are either crystalising a loss or a gain.

So if you are in investments which move up and down a lot, having to take money when they are down is crystalising at a bad time.

This risk is usually higher in the years just after retirement. Why?

1. Your pots are probably the largest they will be, so any percentage drop means a bigger fall in actual cash amounts.
2. Your State Pension (providing some of your income) may not have started yet.
3. Many people spend more in the earlier years of retirement enjoying their new found freedom.

The last two points mean you may be taking more in these years, making any bad outcomes worse.

Below is an example. These are random annual returns each year in retirement. Both patterns average 5% a year over the whole 28 years. The first has most of the bad years at the beginning and the second has these in the middle or end.

For someone taking more initially as their State Pension hasn’t started yet and they are happy with no increases from age 75, this leads to the following two vastly different outcomes.

Even though both take the same income each year and both get an average 5% return over the whole period, one runs out of money after 16 years whilst the other still has a pot of nearly £100,000 after 26 years.

The timing of returns is therefore even more important than the overall average!

How can I avoid this when I am at or in retirement?

One way to avoid this is to match the income payments you expect to take in these earlier years with investments which are less likely to go up and down so much.

Ideally you want to be invested in a fund with a very low risk of giving you a loss over a short term period, say 5 years. You can allocate the total payments wanted in that period to that fund. This means you are unlikely to need extra money from the rest of your assets to meet these payments.

Two types of funds can help with this.

• Ones where the underlying investments mature at the right time to make the payment you need.
• Ones where the underlying investments get most of their return from income payments.

With these as long as you get the income or end payments its much more likely you will get a positive return over 5 years, even if their values move up and down over this time. Funds of this nature can still provide a good return, they may aim for a total return of 2-3% above cash. This may be a little less than a fund focussed on growth, but crucially will have a very low risk of an overall negative return over say 5 years.

If you have put what you need in these funds, you can leave the remainder in growth type assets. This provides the possibility of additional longer term returns on money you don’t expect to need for income for some time.

What matters just before retirement?

As you approach retirement, what you don’t want to happen is the value of your pot to fall just before you retire and start taking money.

Imagine a 20% drop just before you retire, that’s means your tax free cash lump sum is now 20% lower and your remaining pot to provide an income is also 20% lower right from the start!

How do I try avoid this?

In simple terms you want your matching/growth split to gradually move into the split you need at retirement. You want this to start happening in the period 5 to 10 years before retirement.

Lets take the example pension pot payments to give the total overall income you want below. Let’s say you want to match the first 5 years payments when you retire.

• 5 years away from retirement you can still be in all growth type assets as you don’t expect any payments for the next 5 years.
• 4 years away the first years payment you expect comes into that 5 year period, so the amount needed for the first year in retirement is moved into the more matching type fund.
• 3 years away and the first 2 years are now in matching fund.
• 2 years away, first 3 years in matching fund etc

Gradually this moves you to the split you need at retirement based on your specific plan and matched period wanted.

Then once you retire, you can either decide either to let the 5 years of matching run down to zero as you age, or keep the period of 5 years constant. If you do the latter the value of the next 5 years payments are always in matched funds on a rolling basis like an ongoing buffer.

Tax free cash

Another big factor to consider before retirement is whether you expect to take a 25% tax free cash lump. If so, having 25% of your pot (plus 1% to meet any fees) in a cash/money type fund as you near retirement has many advantages.

This total 26% in a money fund means if you decide to take your lump sum at any point before your expected retirement, the cash is there to pay it. This removes the risk you need to sell 25% of your total pot to pay your cash lump sum at a bad time.

Well performing money funds, made up of very short term cash deposits and debt, are currently returning around 5% a year, so the reduction in overall pot growth is small, but risk is greatly reduced.

Why is this approach different to current default funds?

If you pay for advice an adviser will work out all the above for you. They will design you a tailored individual investment strategy. However, a large proportion of people do not take advice.

Around 90% of those who don’t take advice use default funds. Lots of current default lifestyle funds gradually move people from growth type assets into more matching type assets. This is good.

However, they have one key flaw. They do not know what type of matching asset may be right for you.

• If you want to take some or all of your pot as a lump sum, then cash is the best matching asset for some, or all of your pot
• If you want to use your whole pot to buy a guaranteed income at retirement, then long term bonds are the best matching asset for your whole pot.
• If you want to take your pots flexibly over your lifetime, then the best matching assets depend on your expected cash and income payments needed.

Put simply, as the provider and investment manager have no idea how you expect to take your money, they cannot get this right on an individual level, they need to guess what is right.

As the FT points out in this article this has led to some bad outcomes. Many people were automatically moved into long term bonds at retirement, even though they had no intention of ever buying a guaranteed income (annuity).

Those bonds fell in value heavily when interest rates rose. That was fine for those buying a now lower priced annuity, but most people were not. They simply had a much lower pot at retirement to take cash and/or income from because the default investment didn’t match what they planned to do.

How can Guiide help?

From your current plan built with us we already know:

• When you expect to retire
• Whether you expect to take a 25% tax free cash lump sum
• The pattern of income payments you expect to take.

We can also ask…How long would you like to more closely match the expected income payments for? We allow a range between 5 and 10 years.

By providing this information to a provider and investment manager they can split your pot between three suitable funds.

Here is an example below.

This is one of the main features of the new guided retirement solution we are providing soon.

Each year you may change your plan, but once we know your latest updated plan, your investment split is taken care of for you automatically. Its like a default fund but tailored specifically for you and your plan. You plan can even be extended to include your partner’s income also.

If you have any interest in this product let us know below if you haven’t already.

We are also always happy to answer any feedback, suggestions or questions you may have. Just email us at contact@guiide.co.uk if you do.

I like the sound of this, keep me informed……

All of the above is intended for information only. Further details of the product will be provided in due course. Other pension products are available and if you are unsure on what type of product or investments could be right for you, we recommend that you seek regulated financial advice.