Pension freedom has placed the issue around drawing an income from a fixed fund onto centre stage. The nature of retirement suggests that there is no more capital to be added, so what is there has to be nurtured to the end, whenever that may be. Although the starting fund size may seem large, this can disappear quickly, like bathwater after the plug has been pulled.
Conventionally, financial advisers will offer some form of cash flow planning to model the phases from accumulation, through to de-cumulation and eventually to legacies for favoured relatives and deserving charities. The problem with cash flow planning is that it will show an answer, supported by schedules and a long list of assumptions. The plan will take on a life of it’s own, divorced from reality, because as most soldiers can recite, few plans survive first contact with the enemy!
Think about investment returns; most cash flow planning will need an assumption on investment returns, usually after charges, say 4%. This will then drive a huge number of dependent calculations, which will immediately become misleading if the actual return in year 1 is -7% or anything other than 4%. Where this is especially misleading is where a net loss after withdrawals is recorded.
Anyone who has invested for any length of time will be familiar with the phrase, “pound-cost averaging”, this is the damping effect on investment values that occurs when regular investments are made into an asset that has a volatile value; some months, when the value is high, you get very few units, other months when the value is low, you get many more units. Over the time of the investment, the overall unit price is averaged, giving you a better return on your investment than you might expect.
Unfortunately, when you are drawing down from an investment to provide regular income this process works in reverse, so falls in the value of units hits the overall investment harder than you might expect. Some commentators have even described this process as “catching a falling knife” or “pound-cost ravaging”, to get over the enormity of the issue.
Putting some basic numbers to it illustrates the process. If you started with £1000 as shares and the value fell by 10%, you would be left with £900. If the value of the shares rose 10% you would only have £990; you would need a return of 11% to recover the original loss. If you are selling units to generate income, as the unit value falls, you need to sell more units for the same income. When a recovery comes, you need a larger recovery to mitigate the fall in fund value, as you have many fewer units.
Intuitively, if you were going to sell your house and house prices fell sharply, you would hold the sale until the market recovered; if you did not have to sell then you would wait. As advisers, we would set up your portfolio to allow this behaviour - not selling growth assets at a bad moment as we have an alternative. (We appreciate that not having your pension income one year is NOT an acceptable alternative!).
Think of your portfolio as three pots; cash, a low volatility asset and a growth portfolio; under good market conditions, we would pay you cash and refill the cash pot from the low volatility asset and growth fund surpluses. Under poor market conditions we would pay you your cash and replenish from the low volatility pot, waiting for market conditions to improve. We can adjust the relative risks by altering the size of the pots and the underlying investments, so the foundation with this, as with most financial advice, is a really good dialogue with your financial adviser.
A cash flow plan is only as good as the underlying assumptions and your current situation; your long term plan will need to be flexed to reflect what has actually happened in the recent past, what you actually need and what you would be willing to tolerate in the future. Consequently, we put a high value on regular, planned advice.
If you would like to know more about how we can help you plan and realise your financial goals then contact us at firstname.lastname@example.org or call us on 01223 792 196.
The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.