There is a lesser-known danger that could significantly erode the value of your pension pot, especially during the initial years of your retirement. Known as ‘pound cost ravaging,’ this threat can lead to a triple jeopardy scenario for retirees: a decrease in the overall value of their pension fund, compounded losses from withdrawals, and a potential reduction in future income. This phenomenon, also referred to as negative pound cost averaging or sequencing risk, can make the early years of retirement perilous for the unwary investor.
The Triple Threat of Pound Cost Ravaging
Imagine stepping into retirement and facing an immediate financial downturn. Not only does the value of your pension fund drop due to market fluctuations, but the income you withdraw further depletes your capital. This, combined with a potential drop in future income, can leave you in a precarious position. This is the essence of pound cost ravaging – a danger that is most acute at the beginning of retirement when it’s challenging to recover from significant losses.
Moreover, continuing to draw income in these early years can ‘crystallise’ these losses, making it even harder to rebound financially in the future. The act of taking money from diminishing investments early on can cause disproportionate harm to your retirement savings, making it difficult, if not impossible, to restore your portfolio to its former strength.
Understanding Pound Cost Ravaging
In today’s Daily Mail, Ed Monk, from Fidelity International, explains this concept with a simple illustration. If you begin your retirement withdrawing income during a period of strong investment performance, you’ll need to sell fewer assets to maintain your desired income level. This scenario, depicted in financial illustrations as a ‘good start,’ allows your pension pot to remain relatively robust even if the market takes a downturn later on.
Conversely, starting your withdrawals during a market slump means you’ll have to sell more of your investments to sustain the same level of income. This ‘bad start,’ often represented by an orange line in graphs, results in a significantly smaller pension pot over time. The crucial takeaway is that the timing of your withdrawals can dramatically affect the longevity and health of your retirement savings.
Strategies to Protect Your Retirement Savings
Pre-Retirement Planning
The best defense against early retirement market shocks is preparation. Having a diversified income strategy that includes cash reserves or other assets can help you avoid withdrawing from your pension during market downturns. Monk suggests having enough cash saved to cover two years of income, allowing your investments time to recover from any initial losses.
Navigating Market Downturns Post-Retirement
If the market takes a dive shortly after you retire, there are several strategies to consider:
- Use Cash Reserves: Prioritise spending from your cash savings to shield your investments from unnecessary sales.
- Rely on ‘Natural’ Income: Withdraw only the dividends or interest your investments generate, avoiding the sale of assets.
- Reassess Investment Strategies: Consider whether your current investment approach is still suitable for your retirement goals.
- Adjust Withdrawals: If possible, reduce or pause withdrawals to allow your portfolio to recover.
- Delay Retirement: If circumstances allow, postponing retirement can give your investments more time to grow.
- Explore Annuities and Drawdown Combos: Annuities provide guaranteed income, while drawdown plans offer flexibility; combining the two can maximise retirement benefits.
- Be Opportunistic: For those who can afford the risk, market downturns may offer investment opportunities at lower prices.
In Conclusion
Retirement planning is fraught with potential pitfalls, but by understanding and preparing for risks like pound cost ravaging, you can secure a more stable financial future. Whether through strategic withdrawal planning, diversifying income sources, or adjusting retirement timelines, there are numerous ways to protect your pension from the vagaries of the market.