How to avoid the drawdown downside

This article is part of
Combine harvest

Before pension freedoms, the conventional wisdom was that drawdown was only suitable for those with funds of more than £100,000.

There were obviously exceptions as some advisers pointed out that it was not necessarily the size of the pension fund that determined suitability but personal circumstances. This meant that clients with more modest funds were advised to take the drawdown route, but only after going through an in-depth advice process which included a proper risk assessment.

However, pension freedoms removed the annuity handcuffs and opened the door to drawdown for the mass market because certainty went out of fashion and flexibility became the new norm. But nearly one year after ‘freedom day’, many of the new drawdown investors may be having second thoughts as the recent turmoil in the global market has resulted in lower fund values. Over the past 12 months (to 1 March 2016) the FTSE All Share index has fallen by around 9 per cent, and consequently, the value of drawdown funds (where monthly income has been taken) have fallen in value by a much greater amount because of the ‘sequence of returns risk’.

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For many people, sequence of returns risk is something they may be aware of as a concept, but have little appreciation of what it means in practice. The purpose of this article is to show how sequence of returns risk actually impacts on a drawdown plan using the actual market experience over the past 12 months. It goes without saying that one year is too short a period of time to analyse the long-term benefits of equity investments, but it does help focus on the impact of this important risk.

In conjunction with Partnership, we modelled some examples of drawdown over the past year using actual market returns. The idea was not to suggest that an annuity purchase or drawdown was a better option than the other, but to highlight the effect that falling stock markets have on pension drawdown. We compared the income from an annuity with the same income being taken from a drawdown. We assumed a man aged 65 purchased an enhanced level-term annuity on 1 March 2015 with a pot of £100,000, and that his medical conditions included diabetes, high blood pressure and high BMI. With the drawdown, one example assumed the pension pot was invested in a FTSE UK All-Share Index fund and the second example assumed a fund with a 60 per cent equity content.

Fund values

The results from the two examples should come as no surprise; the All-Share index fund was the most volatile and resulted in a lower fund value of £84,496 whereas the 60-40 fund was less volatile and consequently cushioned the fall in the fund value to £91,404. Obviously in a rising market we would expect the reverse with the All-Share fund showing bigger returns.

These results are obviously time-sensitive over such a short period, and when the numbers were done to the end of January 2016 the fund had fallen to £83,605 and £89,916 respectively.