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26 May 2021
Risks investors face in drawdown
Understanding and managing risk in retirement.
About the author
Pension Freedoms, introduced in 2015, granted investors greater flexibility in how they choose to access their pension savings. But this also meant that the responsibility to make important retirement planning decisions shifted to the individuals, and the burden of risk is now placed on their shoulders.
For those approaching drawdown, or who have already begun, the objectives and risks you face now are different to the ones you faced while accumulating wealth. By and large, the main objective is to provide a sustainable income to meet your lifestyle requirements throughout retirement, as well as passing wealth to the next generation. Those objectives present the following risks.
Inflation describes the increasing cost of living over time or, in other words, the declining purchasing power of your money.
Though often overlooked, inflation can have a significant impact on real returns for investors over the long term, even during time when inflation is deemed under control. A recent article in the Financial Times pointed out that “even if inflation broadly aligns with the Bank of England Monetary Policy Committee’s target of 2 per cent per annum, this compounded over time leaves only two-thirds of the starting value after 20 years and less than half after 40 years”.
Inflationary risk can be moderated by investing in a diverse range of asset classes that have historically produced consistent returns at above the rate of inflation, such as equities, commodities, inflation-linked bonds and property.
Humans across the globe are living longer than in previous decades, because of better health care, more health awareness and innovative medicines and treatments. Office for National Statistics (ONS) figures show that an average man retiring at 65 in the UK in the early 1980s could expect to live for 13 years. By the middle of the past decade that had increased to 19 years.
Longevity, whilst undoubtedly desirable, brings additional costs that need to be planned for, such as the increased likelihood of requiring residential or at-home care in your later life. As this trend continues, investors will need their savings or investments to work harder and smarter for longer.
Sequencing risk is the risk presented by making withdrawals from your portfolio in different market conditions. The same pattern of withdrawals can have very different results on the future value of the portfolio, dependant to the concurrent pattern of returns generated.
A combination of high withdrawals and poor returns for a prolonged period can seriously inhibit the portfolio’s potential to meet your income needs in the future. This is particularly true if this pattern occurs in the years immediately after retirement, when the portfolio value is typically at its highest and there are many years of retirement remaining.
This risk can be managed by establishing a sustainable and practical income in early retirement, while ensuring that the portfolio’s asset allocation is appropriate for the returns requirement. Reducing, or temporarily halting, income withdrawals in times of market downturns (and living off cash reserves or other sources of income during these periods) will also allow the portfolio time to recover.
As with all market participants, investors in drawdown will find their portfolio value subject to day-to-day market movements and volatility. Market risk can be mitigated through diversification across various asset classes, sectors and geographies, helping to ensure smoother returns over time.
It’s clear to see that investors approaching drawdown face a range of risks and challenges, which is why it’s important to seek guidance from investment professionals who can help you to implement strategies to mitigate these risks. Get in touch if you’d like to discuss your own circumstances and how we could help.
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