It might not sound like the most scintillating of topics, but understanding the impact that sequence of return risk can have on a Drawdown fund is important if you’re going to make the right decisions about your pension.
To help explain it, we’d like to introduce Warren.
Lucky Warren retires at age 60. He has an initial Drawdown fund of 200k, withdrawing £12k income each year from his plan. His life expectancy is 83.
Let’s look at three different possible growth scenarios. Investment performance in each scenario delivers an average growth of 5% over 30 years.
Scenario 1: Consistent Investment
- Warren’s fund achieves 5% growth each year with no volatility.
- This supports his income withdrawals throughout retirement.
- His fund will last until age 88 – comfortably beyond his average life expectancy.
Sounds pretty good, but it’s an unlikely scenario. Investment performance just isn’t that consistent.
Scenario 2: Strong Start
- Whilst delivering an average 5% growth over the full term of the investment, performance in the early years is stronger.
- Warren’s fund shows good early performance with only two years of negative returns in the first 10 years.
- His fund will last until age 94. That’s well beyond his average life expectancy.
So, despite the same average investment return, the fund lasts much longer than in scenario 1.
Scenario 3: Poor Start
- Despite delivering the same average 5% return over the full term of the investment, the early years are not as strong as in scenario 2.
- There are four years with negative returns in the first ten years.
- Poor Warren will run out of money at age 76. That’s seven years before his life expectancy. And with more than half of people outliving average life expectancy, Warren could be facing even longer with no income from his pension.
Warren is at risk of ending up with no pension income for the last seven years of his life, maybe longer. He’s also left with nothing to pass on to his beneficiaries.
Please note: these examples don’t take into account state pensions, or any other pensions, savings or investments Warren may have.
What does it all mean?
While the average return over 30 years is the same in each case, the outcomes are quite different for Warren. This highlights the fact that when in drawdown, it’s the order, or sequence, in which returns occur rather than the average return over time which really makes a difference.
Sequence of returns risk also applies to inflation. Higher inflation in the first decade of retirement means that you may need to increase withdrawals earlier in retirement to maintain the purchasing power of your income for the lifestyle you’d like to live.
But the more you withdraw, the sooner the funds run out, so it’s a balancing act.
What do you need to do about it?
There are a number of options available to help with sequence of returns risk:
- Choosing lower risk fund
- Buying guarantees
- Securing a guaranteed income
- A mix of these options