Q: I am about to retire and have rejected an annuity. I would like some flexibility on how I take my income and I felt the implied returns were too low. I know drawdown has risks, but how can I minimise them?
A: Guy says:
A useful rule of thumb for retirement is that portfolios should be able to sustain income of 4 per cent a year for a long time. They should also hold a mixture of assets and be sensibly managed. For most people, most of the time, this is OK. Although there are no guarantees, risks need to be covered and your situation updated regularly.
The priority at this stage in your investing life is to manage your risks effectively. You will need to support income from your portfolio for a long time, so I think you need to be concerned about investing risk, inflation and sequencing risk.
Managing your risks
Investing risk is well known. Markets go up and down. This means you need the right spread of investments. I really favour clients holding government bonds, despite the low yields, because they really improve diversification. Next time the stock market falls you will be very glad you were holding bonds.
Inflation risk is also easy to understand. Your need for income is likely to increase with inflation and you should try and have a portfolio that offers you protection against this. A large rise in inflation will quickly make income fixed in pounds undesirable. For example, if you have all your money in savings accounts you will have capital security, but you are very exposed to inflation.
The way to hedge this risk is to have investments that participate in the global economy and give you a share of their growth. This means the stock market.
Sequencing risk is important but a bit trickier to explain.
Generally, in retirement people like to take fixed amounts of income each year to meet their costs. The stock market can move around but your expenses tend to be more predictable.
The problem with taking fixed amounts of income is that the percentage this is of your portfolio changes as the portfolio value changes. If your portfolio doubles, the percentage halves and vice versa. The problem, obviously, is when the portfolio falls in value.
If we look at the extreme situation above, your withdrawals could double as percentage of portfolio and what was 4 per cent becomes 8. That level of income is clearly unsustainable, and your portfolio will rapidly erode. The reason we call this sequencing risk is because markets tend to recover losses, but if you've taken income you may have eroded your capital base. Your portfolio won't rebound and you can't catch up.
The greatest sequencing risk is early in retirement for the simple reason that you have the longest time to live, and take income, at this point. One of the strategies you should discuss with your adviser is how to manage this risk early in your retirement.
There are a couple of general points I should make about sequencing risk. The greater the diversification, the less the ups and downs and the less the sequencing risk and therefore the lower your risk of running out of money. This is the tragedy of the Woodford saga and the DIY investing platforms. Many people ended up with far more risk than they anticipated.
Similarly, it is always a good idea to try and reduce your costs of investment. The less you pay, the more money you should have left for your retirement.