DrawdownSep 5 2019

Risks and sequence of returns in retirement

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Risks and sequence of returns in retirement

Most people may wonder what the biggest risks facing them are apart from the obvious, outliving their pension pots. 

The introduction of pension freedoms in 2015, means that individuals have greater choice on how to decumulate their retirement income, albeit exposing themselves to greater risk. 

So what are the risks faced once people get into retirement? 

Outliving your pension 

Fiona Tait, technical director at Intelligent Pensions believes the biggest risk is a lack of understanding by people on how much they can afford and running out of their money too soon. 

She says: “The average retirement age in the UK is still in the mid-sixties, 65.1 years old in 2018 for men, and 63.9 years old in for women, and more and more people choose not to buy an annuity at this age.” 

“There are some good reasons for this however, the result is that people are not securing a guaranteed income for life and must therefore budget and manage for a retirement which could last a lot longer than they think,” adds Ms Tait. 

Udit Garg, head of wealth management at Sun Global Investments agrees. 

He says: “Rising life expectancy means that more people in the UK will reach retirement age than ever before, although this is a good thing, this also means that there are more growing pressures of late-life financial risks if people are unprepared.” 

Lorna Blyth, head of investment solutions at Royal London highlights how concerns and income needs will shift over the course of retirement as some might want to prioritise holidays while others may care about more long-term costs. 

She adds:  “There is no silver bullet which will meet all our preferences for income, security, flexibility and value for money and ultimately we will need to trade off some preferences for others.”

Ms Blyth says things to consider include: 

  • Income needs
  • Existing retirement savings
  • Personal circumstances
  • Life expectancy
  • Long term care needs
  • Impact of costs and charges
  • Investment strategy and impact of investment returns
  • Attitude to risk
  • Capacity for loss
  • Ms Tait says another significant risk is scams as those  who have spent years building up a retirement fund could lose the entire amount to a scam.
  • According to Ms Tait, scams are constantly evolving and even financially savvy individuals do not always recognise one when they come across it. 
  • She adds:  “The regulators have introduced a number of initiatives to address this issue but the greatest protection will come from a long term relationship with a financial adviser where trust is built up over a period of time.”

Sequence of returns risk 

Many in the industry highlighted that sequence of returns is the biggest risk facing those in retirement. 

Sequence of returns is that the timing of withdrawals from a retirement portfolio will have an adverse impact on the overall return available to the investor. 

The losses may be more pronounced for the investor who is dependent on the income and is no longer making contributions that could reduce the losses.

Ms Tait points out that those who choose not to buy an annuity and remain in drawdown are still subject to investment risk. 

She adds:  “Negative returns in the early years are particularly damaging as they cannot be offset against growth achieved prior to impact.”

This concern is echoed by several others in the industry. 

Ricky Chan, chartered financial planner and director at IFS Wealth and Pensions says: “A poor sequence of returns in retirement while in drawdown, dramatically increases the chance of the pension fund being exhausted. It’s also sometimes called “pound-cost-ravaging”.”

Mr Chan says this is because of the potentially detrimental effects income withdrawals can have on the pension fund value during periods of negative returns.

Mr Garg confirms: “The biggest risk in this is timing. If an individual decided to withdraw at the wrong time, their overall return will likely be damaged, especially if this is done during a bear market, so it is best to have a long term strategy in place.”.

Mr Garg identifies the following long-term strategies to minimise sequence of return risks:

  • Working up until as late as possible, especially during peak earning years so that more money can be contributed
  • Saving and investing at all times (no matter how small)
  • Have a well-diversified portfolio in place to help mitigate risks. Having all your eggs in one basket is not worth the potential dangers.
  • Cut down on unnecessary costs

Market Crash 

Some in the industry warned that retirement portfolios in drawdown can also be adversely impacted by market crashes. 

Mr Chan says a market crash type scenario can reduce a retiree’s defined contribution pension fund which often means a lower income can be taken in drawdown or when buying an annuity. 

He warns that an excessive withdrawal rate risks the pension pot being prematurely exhausted can prove to an acute problem if investment growth is insufficient to match it. 

Mr Chan also highlights that if one spouse “pre-deceases” the other one in retirement, sequence of returns could drastically reduce the surviving spouse’s lifestyle if they did not have much pension benefits themselves. 

Ms Blyth believes investment solutions need to balanced against rising life expectancy where capital needs to grow and one that reduces the risk to limit impact of market falls. 

She says: “This is balancing as moving to a strategy which is too defensive removes the significant potential benefits from compounding and could risk an income shortfall.”

“This is where a well-diversified asset mix which retains some growth element can offer equity like returns with reduced volatility and can really help to deliver a sustainable income,” Ms Blyth adds.

saloni.sardana@ft.com