Income In Retirement – Consistency Is King

We looked last time at the importance of reviewing your investment strategy if you intend to use a ‘drawdown’ pension during retirement and leave your fund invested for the longer term.

For many the biggest risk of using a drawdown pension, rather than an annuity, is that the fund will run out during their lifetime. Of course, none of us can know for sure how long we will live and for most the tendency is to underestimate life expectancy.

One of the most important factors in determining how long your pension fund will last, is the consistency of the returns that are generated throughout the lifetime of the investment.

Many investors will be aware of the concept of ‘pound cost averaging’, which is where a regular payment into an investment is made and you ‘buy into the market’ at different points in time. The principal here is that it is actually positive to be buying investments when the market is lower, as you will be buying more shares for your money.

This point can be illustrated using a very simple example over a 3 month period, comparing a lump sum investment purchase of £30 vs a monthly payment of £10 per month.

 

Example 1 – Shares Purchased Up Front

Amount Invested Share Price Shares Purchased Final Value
Month 1 £30 £1.00 30
Month 2 N/A £0.50 N/A
Month 3 N/A £2.00 N/A £60

 

Example 2 – Shares Purchased Monthly

Amount Invested Share Price Shares Purchased Final Value
Month 1 £10 £1.00 10
Month 2 £10 £0.50 20
Month 3 £10 £2.00 5 £70

 

As you can see, in the second example, the fall in the share price in month 2 has been positive, as more shares where purchased, when have then gone up in value, meaning we have £70 at the end of the three months, rather than £60.

The issue with a drawdown pension is that the opposite of the above phenomenon is also true. This is where more shares have to be sold to provide the same level of income. So using our above example, if we wanted an income of £10 per month, 10 shares would need to be sold in month 1, 20 shares in month 2 and only 5 in month 3. The sale in month 2 of 20 shares would really damage the total investment over time.

As a result of the above, we favour investments that produce very consistent returns during retirement. It is far better to have a return of 6% per annum consistently every year, than an average of 6% per annum, but spread over a wide variety of different outcomes (-6% one year, +12% next year for example).

This is best illustrated with another example as follows:

 

Starting fund of £10,000, £500 withdrawal made at the end of each year.

 

Year 1 Year 2 Year 3 Year 4 Year 5
Consistent Return

(5% per annum)

£10,000 £10,000 £10,000 £10,000 £10,000
Variable Return

(average of 5%)

£8,500 £7,575 £7,984 £7,963 £9,214
Return In Variable Scenario -10% -5% +12% +6% +22%

 

As you can see, in both scenarios, the average return is 5% per annum, however in the variable return scenario, the first years are poor, meaning that we have a smaller fund to carry forward. Despite the large positive numbers in the latter years, the second fund has still not recovered to the same level 5 years later.

Of course the above is a simple example, however it does illustrate the importance of consistency when thinking about investing for retirement.