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The biggest danger to your pension savings – and how to neutralise it

Now we come to an extremely important aspect of withdrawing money from your pension: the need to ensure that your income is not excessive, which could cause irreversible damage and derail the vital requirement to provide an income for the rest of your life.

If the financial markets could be relied on to rise smoothly at their average historic pace, there would be no problem: you could sit back and simply spend the income as it was produced – and, if need be, gradually sell assets at regular intervals to boost your income.

As we all know, the markets cannot be relied on to behave in this convenient way. This can pose acute dangers for anyone who relies on a portfolio of investments for retirement income

However, you may be able to skip this part altogether, depending on which of our portfolios you choose.

The warning above applies to anyone who tops up the natural income of their portfolio with periodic sales of assets – so it will definitely apply to those who have invested their money in the high-income portfolio and could also affect those who opt for the compromise portfolio; we cannot say for sure as it will depend on the yield of this portfolio, which varies constantly, at the time you invest.

However, the warning does not apply to those who take only the natural income, in other words those who have invested in the inheritance portfolio and perhaps, depending on the yield at the time, those who invested in the compromise portfolio.

Let’s imagine that you have £300,000 in your pension and that it is invested in the high-income portfolio, which is intended to generate 5% income a year. Your target income from the portfolio is therefore £15,000 a year, equal to £1,250 a month or £3,750 a quarter (this target income will increase every year in line with inflation).

The natural yield of the high-income portfolio at the time of writing is 4.24% (we will aim to publish up-to-date figures on this website), which equates to £12,709 a year, £1,059 a month, or £3,177 a quarter. This means that the natural yield falls short of your quarterly income target of £3,750 by about £573 a quarter (or £2,291 a year).

You raise the extra money you need by selling a small proportion of your total pension assets every quarter.

We suspect that this idea causes disquiet among some savers, who feel that by eroding their capital, even slightly, they are on a slippery slope that will end in them having nothing. But in fact selling assets slowly can make perfect sense.

If you refuse to use any of your capital, you guarantee that there will be something left unspent when you die. Of course, some people want this, and the inheritance and compromise portfolios are designed for them. But those with more modest savings will normally need to take as much income from their pension as possible for their own needs, and that means not leaving money behind for the next generation.

Look at the question of gradually selling assets another way. At the age of 75, you will clearly need less money to fund the remainder of your retirement than you did at 65, so why not spend the difference in that time?

However, for anyone who does gradually sell assets as opposed to relying on the income generated naturally, there is an important caveat. Over the course of a normal retirement there are bound to be times when the stock market falls significantly. For example, the FTSE 100 index of Britain’s biggest companies has fallen by 20% or more on five occasions in the past 30 years (in 1987, 1998, 2000–03, 2007–09 and 2015–16). On this basis, we can expect on average a fall of this severity every six years.

If you are used to selling, to use the example above, £573-worth of your assets every quarter to top up the natural income, you will have to sell more shares (or fund units) to raise that sum if the markets have just fallen.

For example, let’s simplify matters and assume that you have just one fund and its unit price has just fallen from 100p to 90p. At 100p you would need to sell 573 units to generate the £573 you want, but if the units are worth just 90p each you will need to sell 636.5 of them to get the same sum.

But selling more units than you expected also means that, when you come to make your next withdrawal, you have fewer units left generating natural income. As a result, your future income requirements will in turn have to be met by more sales. These sales again diminish the number of units left. In this way, a vicious cycle can be established that could see your capital eroded much more quickly than you had intended.

Fortunately, there is an easy way to avoid being caught by this trap.

Your exact tactics for selling assets to boost your income

Selling too many assets when they have fallen in value puts the long-term sustainability of your income at risk, as we have just explained.There is also a related danger: being tempted to sell more of your assets when they have gone up in value. You might say to yourself: “Oh look, my pot has risen by 10% – why don’t I take that extra money and spend it?”

In fact this would be a dangerous course of action: selling 10% of your assets means that they would produce 10% less natural income in future – a shortfall that you would have to make up by selling even more assets from that point onwards, starting the same vicious circle we warned about above.

To avoid both of these dangers, we have this simple rule to keep your income sustainable: sell a maximum of 1% of your original fund units or shares each year (0.25% a quarter).

Note that you are not selling 0.25% of the value of the fund at the time, but 0.25% of the number of fund units or shares that you bought when you set up your portfolio at the outset. You will therefore need to keep handy a record of this information.

Using this rule means that the ability of your overall pot to generate natural income will decline by 1% a year, which is manageable; a 10% decline, for example, would not be!

How you spread asset sales across the various funds in your portfolio also matters. Our rule is to sell a maximum of 0.25% of the units (or shares) in each fund every quarter, irrespective of whether each fund has risen or fallen in value. This, apart from being simpler than other possible approaches, preserves the income-producing potential of each fund and avoids having to take a bet on which ones are likely to perform better in the future.

It also means that you are preserving the overall portfolio’s original division of income-generating potential between the various types of asset (shares, bonds and property).

If the value of the portfolio as a whole has gone up, the amount you realise from selling 0.25% of it will also increase, so your available income does rise. You may choose to take less than 0.25%, of course, which would be good for the long-term health of the fund. Or you may, if you have previously had to dip into the main cash reserve, top it up again with the extra money.

If, however, the overall value has fallen, you should still limit asset sales to 0.25% a quarter, making up any shortfall in your income from your main cash reserve.

The following table shows how this process might work for one fund, with £37,500 invested in it at the outset. We have imagined that the fund price rises slightly in the first year, falls in the second and then recovers. The income, by contrast, rises more steadily from one year to the next.

There are several things to note about the table:

• We have made some fairly benign assumptions about how the fund price fluctuates. If the markets were to hit a bad patch the price could fall more severely. Our practice of selling a set number of units each quarter, as opposed to selling enough units to raise a particular sum, prevents excessive erosion of capital. If this causes too large an income shortfall, the difference should be made up from the main cash reserve.

In the second year we have assumed that the dividend has risen even while the fund price has fallen. This is perfectly possible, because the two things are subject to different dynamics. The dividend depends on the underlying performance and profitability of the businesses that the fund invests in, whereas the price reflects the subjective, often short-term opinions and sentiments of the stock market. It is not unreasonable to hope that dividend rises over time will tend to outweigh any loss of income caused by falls in fund prices, although there can be no guarantee.

• Under our benign assumptions, the holding in the fund is worth more after three years than at the outset, even though some units have been sold. Again, this cannot be guaranteed. Our approach is deliberately conservative and designed to cope with more extreme market gyrations, which could result in the holding being worth substantially less after three or more years. As long as the fall is not extreme, this is in line with our strategy and not likely to be a problem.

• A fractional number of units is sold each quarter. This is no problem for ordinary funds, such as Artemis Income, but sales of shares in investment trusts, such as City of London, have to be made in whole numbers. You may have to make slight adjustments from quarter to quarter to accommodate this.

• The total income from the natural yield and the sales of units rises, under our assumptions, from one year to the next. Again, this cannot be guaranteed.

‘Our income has fallen. What do we do?’

“I have an investment portfolio that produces an income for me and my husband, but for the past six months the natural income from the portfolio has dropped and is not sufficient for us to live on. How do I top up this income through other means?”

This is the kind of situation that many retired people could face, although we hope that the portfolios we have suggested will minimise the risk of such an outcome. If it does happen, the first thing to ask is whether the fall in natural income is likely to be temporary or permanent.

If temporary, the ideal source of top-up income would be your cash buffer. If permanent, on the other hand, and you had to use the cash buffer indefinitely, it would eventually run dry.

If you had been relying on the natural income alone up to this point, it would be fine to make some asset sales in addition, although not beyond our suggested level of 1% a year. If you had already been selling 1% of your assets a year (and expect the decline in natural income to be permanent), it could be worth getting some annuity quotes.

Depending on your age and state of health (and your husband’s), you could find that your remaining pension pot would buy the annual income you need. You would need to specify a joint-life annuity as you are a couple. An annuity with annual increases, whether these are in line with inflation or by a fixed amount each year, would be a good idea.

If none of those suggestions works, you may need to consider releasing some of the money tied up in the value of your home and using it to top up your investment portfolio, thereby generating more income (see here for more on taking money from your property).


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