Benefiting from low volatility. But for how long?

Last year, for the second year in a row, all major asset classes delivered positive returns. The best performers were emerging and developed market equities.

Asset prices have been supported by a parallel increase in economic growth around the globe, low inflation and support from many central banks in the form of low interest rates and the maintenance of quantitative easing.

All-time highs with low volatility

Into 2018, many equity markets have continued to set all-time highs. And this increase has been accompanied by unusually low levels of volatility.

According to the VIX index, there has recently been only a minor rise after record levels of low volatility. VIX gauges the volatility implied by options on the S&P 500 Index in the United States; but implied volatility in the FTSE 100 and MSCI World indices are also near rock bottom.

More progress forecast

The general economic backdrop is as buoyant as it has been at any time since the global financial crisis. Many major central banks and supranational bodies such as the IMF forecast further global economic progress this year.

The lack of volatility suggests investors are reassured by the simultaneous presence of strong growth and low inflation. Even political tensions, such as strained relations between the US and North Korea, have barely affected the advance of stock markets.

Low volatility: an unlikely long-term prospect

A lack of volatility is reassuring for investors, but it is unlikely to remain at such levels in the long-term.

Nevertheless, short-term volatility isn’t an issue for many investors. Diversified portfolios and long-term investments mean a return to more typical levels of volatility is manageable. It can even offer the opportunity for investors to benefit, for example, from pound-cost averaging.

In retirement, factors such as “volatility drag” and “sequence of return risk” can undermine the sustainability of a drawdown income.

When contributions become withdrawals

Once investors begin to withdraw from, rather than add to, their investments, an increase in volatility can raise particular problems.

While in accumulation, investors can drip-feed money into investments – buying when asset prices are falling as well as rising to generate long-term growth. But in retirement, factors such as “volatility drag” and “sequence of return risk” can undermine the sustainability of a drawdown income.

Volatility drag

Volatility drag describes how a fall in the value of a portfolio is hard to restore. For example, a 10% fall in a pension pot’s value would require an 11% rebound simply to return to the starting value. If income continues to be withdrawn during this correction, an investor would need an even larger rebound.

Some investors in pension drawdown can stop withdrawing money from their fund and rely on other sources of income while waiting for a market recovery. But this will not be an option open to all investors.

Sequence of return risk

In addition, an increase in volatility and market correction can also have an impact on those in pension drawdown.

A fall in value during the early years of retirement and income withdrawal can significantly reduce how long a pension fund will last, compared to a fall in value of the same magnitude later in retirement.

This sequence of returns risk is caused by a constant rate of withdrawal on an ever-reducing pension fund. Investors who opt for drawdown over an annuity will often plan to withdraw more from their fund than it is expected to grow. Their pension fund may lose value in the early years of taking an income, and they’re unable to reduce the income they take from it.

An example

Take an investor – now in pension drawdown – withdrawing £5,000 a year from a pot of £100,000. A drop in value of 20% is the equivalent of 4 years’ income. But a 20% fall later in retirement, when the pension pot is £50,000, would be the equivalent of 2 years’ income.

Knowing the possible consequences of volatility

The introduction of pension freedoms brought about an increase in the popularity of pension drawdown. Those who access their savings this way should be aware of the potential challenges they may face in future, and the way a change in volatility could affect their retirement income.

For further insight and expert guidance, please visit Scottish Widows Change Hub.

‘This is a Scottish Widows Paid Post. The news and editorial staff of the Financial Times had no role in its preparation’