Pound Cost Ravaging
With annuity rates low, many retirees avoid or delay annuity purchase. Instead they seek to live off the investments within their pensions. If you are in this situation, even if you are comfortable to continue to take the risk of investing, you face the additional risk of running out of money – longevity risk. A facet of this risk is “pound cost ravaging” i.e. when markets fall, more of your investments need to be sold to generate a constant income. As a consequence there are less investments left to benefit from a rebound in markets. Think of it as the effect of compound interest in reverse.
The payment of a regular monthly pension income is generally preferred; after all, on-going bills and living expenses are mostly regular! Consequently, the approach of many is to take a regular fixed amount as pension withdrawals, which includes part of your pension’s capital. If this approach is continued during market downturns, the surprising and long lasting detrimental effects of post-cost ravaging can easily occur.
Managing this risk is critical, but how?
One approach is just to take the naturally occurring income from your investments, leaving the underlying capital intact. Another possible solution is to select investments with an income or capital value guarantee. Guarantees come at an additional cost and so hinder performance during times of buoyant returns; however, during market downturns they can become highly valuable – think of it as insurance.
Another solution is to build a cash or income reserve to take regular withdrawals from during distressed market conditions. This prevents losses being crystallised when markets fall and leaves your pension investments time to recover when markets rebound, which they invariably do over time. Maintaining two or three years’ worth of income would be prudent, though it took the markets a lot longer than three years to recover from the “credit crisis”. Maintaining such a cash/income reserve does act as a drag on the overall performance of your pension but can be an effective approach.
Author: Paul Newton FPFS, CertPFS (DM & Securities), STEP Affiliate, Cert PMI is a Chartered Financial Planner for Castlegate Financial Management Limited, a firm of Independent Financial Advisers, authorised and regulated by the Financial Conduct Authority. 8 Castlegate Grantham Lincolnshire. 01476 591022.