Investors who chose stock markets over annuities in the three years since pension freedoms have enjoyed strong returns, but the volatility experienced since February could persist throughout the year, creating a dilemma for those ill-equipped to suffer losses, market watchers have warned.
Pensions freedoms were first introduced three years ago this month, leading tens of thousands more retirees to choose exposure to higher risk financial markets - and the prospect of higher returns - over the safety but unimpressive rates offered on annuities.
Jason Hollands, managing director for business development and communications at Tilney, said those who shunned annuities and instead ploughed cash into investment products have done better in total return terms, as both equity and bond markets delivered strong returns during the last three years.
In contrast, investors who chose to buy an annuity three years ago will have suffered.
This is because annuity rates are generally priced relative to the yield on the 10 year government bond, and as the price of those, and most other, bonds, rose in the past three years, the yields declined, and so annuities rates became less generous.
Bond yields began to rise last year as market expectations about the rate of inflation shunted upwards.
But as equity markets became gripped by volatility at the start of February, investors fled to the safe haven of bonds, sending yields back down.
Without the cosy environment of rising equity markets they have enjoyed for the past three years, pension investors who opted for drawdown as a result of pension freedoms face a more uncertain future.
Most will need to take a regular income from their invested retirement pot, irrespective of what markets are doing. In the event stocks are falling, these retirement investors will be forced to sell at a loss, eroding their capital faster.
David Millar, investment director at Quilter Cheviot, said the volatility seen in the investment world during the first quarter of this year is far greater than during the whole of 2017, and he expects it to continue.
"The euphoria experienced in January 2018 was replaced by fear in February.
"Initially it was thought that growth might be just a little bit too strong, driving both inflation and interest rates higher.
"Then, as evidence emerged that perhaps the global economy was not quite so buoyant, the mood swung to fears of stagnation or, even worse, a combination of rising inflation and low growth - stagflation."
He noted that US retail sales have fallen for three consecutive months as evidence that the global economic outlook may not be as rosy as it might have seemed.
Anthony Rayner, joint manager of four multi-asset funds at Miton, said his base case is for economic growth to continue, but said the level of risk in the global economy is higher now than before.
In addition to risks from unpredictable political outcomes, interest rates have been rising in the US and UK.
Fund manager Neil Woodford said he believes these interest rate rises are behind the rise in volatility, as such a policy reduces the level of liquidity in the financial system.
Higher interest rates are designed to curb inflation by making borrowing less attractive and saving more attractive. If that does occur, then the income from bonds should rise, which pushes the price down.
But equities typically underperform when interest rates have been rising for a prolonged period of time, as the level of demand in the economy falls, which would be a problem for retirement investors with a portfolio full of stocks.
Typically, higher interest rates happen as a result of strong economic growth and rising inflation.
Higher inflation is bad news for investors in products such as annuities, as they receive a fixed level of income. Inflation erodes the real spending power of the annuity income people receive now, but if bond yields rise as a result of higher interest rates, that should push annuity rates upwards.
Paul Stocks, financial services director at Dobson and Hodge in Doncaster said annuities remain an option for investors who are worried about volatility.
Mr Hollands added: “Drawdown is not appropriate for everyone, as it involves uncertainty and returns will be variable with a real risk that investors drain their pensions too quickly."
David.Thorpe@ft.com
