How Can You Protect Your Pension from Market Volatility?
Everyone needs a regular income when they retire. For many, this income can be collected through selling off investments. But, of course, trusting your pension income to the market always involves some risk.
For pensioners, the risks of putting money on the markets are compounded by their reliance on periodical withdrawals from their investments.
At gpfm, our Hertfordshire financial planners understand the unique needs of pension investments. That’s why we want to explain the dangers of investing for retirement without proper pension advice and planning.
The Dangers of Market Volatility to Savers
For example, a pensioner, Anne, may calculate that she requires £2,000 per month in retirement. If Anne’s savings are mainly in investments, she will need to sell off enough of her assets each month to reach this value.
The danger of market volatility, however, means that should the value of Anne’s investments drop one month, by say 20%, she may need to sell 1.25 times more units of her investments in order to reach the same £2,000 monthly total.
Compounding the Jeopardy
This market volatility is well understood by savers and all pension advisors must make their clients aware of the amount of risk involved in trusting a large portion of your retirement income to investments.
What is less well understood by those saving for retirement is that there are two factors which compound the dangers of a volatile market – particularly for retirees, since they require a constant flow of income from their investments.
These two factors are ‘volatility drag’ and ‘sequencing risk’. Here is a jargon-free explanation of how these factors could seriously damage your pension income without the correct pension advice and strategy in place.
What is Volatility Drag?
Volatility drag is a technical name for something we all intuitively understand. If you need Anne’s £2,000pcm income from your savings, your portfolio needs to be growing each month, or you would run out of money within a few years.
The danger is that a low-value portfolio has to perform much better than a high value one, and grow much faster month-on-month to be able to sustain this constant income-withdrawal. Let’s look at an example.
If we ignore tax for simplicity, investments worth £100,000 need only grow 2% each month to be able to sustain a £2,000 income-withdrawal with no loss in value. (In reality of course, most pensioners see their savings reduce progressively, but this is just a simplified example.) By contrast, £50,000-worth of investments must grow by 4% each month in order to provide the same income with no loss of total value.
There is a drag therefore on growing small investments. And if you want to turbocharge your investments to overcome this drag, this usually means taking on more risk – something unadvisable to pension savers due to the fundamental importance of their regular income.
What is Sequencing Risk?
Sequencing risk has the potential to put a big dent in your savings through a fall in the value of your investments. ‘Sequencing’ refers to whether the fall happens early or late in your retirement.
The ‘risk’ is that the market value of your investments falls heavily early on in retirement.
When constant withdrawals are not required (i.e. in non-pension portfolios), you can simply decide to wait until the value of your investment rises again before you withdraw anything. But when you need a regular income, you don’t have this option.
If faced with a steep drop in the value of her investments early in her retirement, Anne would have to sell far more of her investments to reach the £2,000 goal than she anticipated. This would mean she had a much small value to grow in time for her next withdrawal. Due to volatility drag, she would therefore be less able to sustain her savings’ total value and may even have to start taking a smaller monthly income.
At gpfm, we understand that pension investments require a smoother, safer ride than investments designed to raise a lump sum of money. We can advise on how to minimise the dangers of volatility drag and sequencing risk, and help you secure a steady income for your retirement that you can rely on.