Converting pension savings to a retirement income: the risks & potential solutions

In March 2014, George Osborne announced the abolition of most of the restrictions on how people draw an income from their pensions.

Effective from April 2015, individuals were able to take as much as they wished from their pension any time after their 55th birthday.

What happened next?

Announcement

Pre-announcement

April - December 2013


£8.6bn of annuity sales in over 260,000 contracts 1

Announcement

Post-announcement

April - December 2015


£3.3bn of annuity sales through c.61,700 contracts1

Down -62%

2016: the trend continues ...

April – June: a further rise in withdrawals of pension savings ...

£1.8bn of pension withdrawals

... this was more than in any other single quarter since freedoms were introduced.2

1ABI pension freedom statistics – one year on factsheet, ABI, 28th March 2016. 2Source: HMRC 'Flexible Payments from Pensions' Data from 1st April – 31st June 2016.

Risks

Income drawdown is more flexible than an annuity. However, it also increases the likelihood that individuals won't be able to maintain their income throughout their lifetime. We take a look at the risks they face.

Life expectancy

A man retiring in 2021 at 65 is expected to live to 87.

A woman retiring in 2021 at 65 is expected to live to 89.1


1 in 4 people over 65 ...

will enter residential care 2


Percentage of 65 to 74 year olds who reported a ...

long-standing illness or
disability in the UK3

Sequence of returns

'Sequence of returns risk' describes
 the effect of the order in which investment returns are delivered during income drawdown.


Research shows that poor returns in the early years of drawdown can significantly affect an investor’s experience. It increases the risk that income will have to be reduced or that the fund will be exhausted before death.

For example:

Example No. 1

The examples below show portfolios of £100,000 at an average of 7% p.a over a period of 25 years – from age 60 to 85.

Portfolio A (blue) shows a constant rate of growth. Portfolio B (red) experiences poor performance at the beginning but recovers later on.

£100,000 starting fund, no income, 15% charges. Growth rates 7% pa. constant (blue) and variable (red).

Example No. 2

If the average rate of growth is 7% p.a. and an income of £500 per month is drawn, Portfolio A will reduce at a steady rate.

When a portfolio experiences poor performance and a constant level of income is drawn, Portfolio B shows that it has a detrimental effect on the value of the pension pot.

£100,000 starting fund, no income, 15% charges. Growth rates 7% pa. constant (blue) and variable (red).

The examples below show portfolios of £100,000 at an average of 7% p.a over a period of 25 years – from age 60 to 85.

ExampleNo. 1Fund with no income withdrawal

Age
Portfolio value
£300,000.00 £400,000.00 £250,000.00 £350,000.00 £200,000.00 £150,000.00 £100,000.00 £50,000 £0.00 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85

£100,000 starting fund, no income, 1.5% p.a. charges. Growth rates: 7% p.a. Constant (blue) and variable (red).

Portfolio A (blue) shows a constant rate of growth.

Portfolio B (red) experiences poor performance at the beginning but recovers later on.

ExampleNo. 2Fund with income withdrawal - £500 a month

Age
Portfolio value
£100,000.00 £120,000.00 £80,000.00 £60,000.00 £40,000.00 £20,000.00 £0.00 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85

£100,000 starting fund, no income, 1.5% p.a. charges. Growth rates: 7% p.a. Constant (blue) and variable (red).

If the average rate of growth is 7% p.a. and an income of £500 per month is drawn, Portfolio A will reduce at a steady rate.

When a portfolio experiences poor performance and a constant level of income is drawn, Portfolio B shows that it has a detrimental effect on the value of the pension pot.

Previously, legislation was in place to help maintain a certain level of income through retirement. For example, by restricting the amount of income that could be withdrawn. These restrictions have now been removed. It is important to ensure that a sufficient and stable rate of capital growth is maintained to sustain income for a lifetime.

Reverse pound cost averaging

Reverse pound cost averaging is ...

... the effect of withdrawing a fixed regular income from a volatile asset. As the value of the asset falls, so more units or shares have to be sold to maintain the same level of income. By selling more units, the fund has less chance to recover.


Examples below:

The example shows the performance from two funds which have the same total return over the period.

However, fund B is more volatile than fund A. Therefore, more units of fund B need to be sold to maintain the same level of income.

Rotate for full chart

Let's take a look ...

The examples below show the performance from two funds which have the same total return over the period. However, fund B is more volatile than fund A. Therefore, more units of fund B need to be sold to maintain the same level of income.

Potential solutions

Income drawdown is an inherently riskier strategy in retirement than an annuity. However, there are ways to help mitigate these risks and improve the chances of generating the required income.

These can be split into an individual's approach to income and some possible considerations when investing.

Approach to income

Understand the "maximum safe withdrawal rate"

For the UK, research suggests a withdrawal rate of 3.36%1 is the highest amount that could be initially withdrawn to allow the potential to keep up with inflation and not exhaust your pot over a‎ 30-year period.

Adapt your withdrawals

After periods of poor performance, try to limit withdrawals in order to help preserve the fund.

Annuitisation

... of part of the pension pot to provide for essential spending throughout retirement.

1 Source: Wade Pfau: Maximum Sustainable Withdrawal Rates for Retirees: Best Practices for Retirement Income Planning, United Kingdom edition. These figures make no allowance for administrative fees and are based on historic returns for a 50% equity allocation over rolling 30 year periods starting between 1900 and 1981. There is no guarantee that these rates will be sustainable in the future.

Considerations when investing

Hold sufficient funds in cash

... to ensure that withdrawals are not made from volatile funds at inappropriate times. This can reduce the risk of reverse pound cost averaging.

Consider starting with a lower % of equities

Independent research suggests starting with a lower % of equities (c.40%) and drawing an income from non-equity assets in the earlier years of retirement. This can reduce the impact of sequence of returns risk.

Adapt your equity exposure to meet your desired withdrawal rate ...

... US research indicates that for higher withdrawal rates, a substantial exposure to equities tends to produce higher probabilities of success, albeit with higher volatility. If the target withdrawal rate was lower than 3.5%, then an asset allocation containing at least 40% equities was 100% successful over a 30-year period.

At a withdrawal rate of 4%, an equity allocation of around 60% was 100% successful over a 30-year period.1

Diversify ...

... portfolios exposed to global assets enhance diversification, reduce country specific risks and can improve returns.

1 Source: Return Sequence and Volatility: Their impact on sustainable withdrawal rates. Matthew B Kenigsberg, Prasenjit Dey Mazumdar, Steven Feinschreiber. The Journal of Retirement, Autumn 2014

Artemis Monthly Distribution Fund

These pension issues are complex. One option which might be suitable for your clients looking for income in retirement is the Artemis Monthly Distribution Fund.

Provides global diversification.
Exposure to equities & bonds.

Best ideas from the Artemis Strategic Bond Fund

Artemis Monthly Distribution Fund: typically 60% bonds, 40% equities

Core income ideas from the Artemis Global Income Fund

Returning 82.5% since launch versus

sector average return of 37.8%1

No.1

ranked in IA Mixed
Investment sector1

3.8% yield

over the last 12 months2

1 Data from 21 May 2012. Source: Lipper Limited, class I distribution units, bid to bid in sterling to 31 October 2016. All figures show total returns with dividends reinvested. Sector is IA Mixed Investment 20-60% Shares NR, universe of funds is those reporting net of UK taxes. 2 Historic yield, class I distribution units as at 31 October 2016.

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THIS INFORMATION IS FOR PROFESSIONAL ADVISERS ONLY and should not be relied upon by retail investors.

Artemis does not provide investment advice on the advantages or suitability of its products and no information provided should be viewed in this way.

The decision to access your pension savings is an extremely important one. Before you do so, Artemis strongly advises you to seek advice from a financial adviser to help you to understand your options. You can also obtain independent guidance from Pension Wise (pensionwise.gov.uk), a government service aimed at helping you understand your options.

Unlike an annuity, which pays a regular fixed income, the level of income paid by the Artemis Monthly Distribution Fund will fluctuate and you may not get back the amount invested. The fund may invest in fixed interest securities and in higher-yielding bonds. The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities. The fund may invest in emerging markets. The fund may use derivatives to meet its investment objective, to protect the value of the fund, to reduce costs and with the aim of profiting from falling prices. The fund's annual management charge is taken from capital.

The amount of tax you will pay will depend on your individual circumstances and tax rules may change in the future. The information provided by Artemis is based on our current interpretation of regulations, which may change in the future.

Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.