Any doom-mongers worried the nine-year stock market bull-run could be about to come to a shuddering end don’t have to look too far for possible threats.
The US Federal Reserve has already raised interest rates across the Atlantic while other economies – including the UK – are widely expected to follow suit in the near future.
The consequences of removing the quantitative easing money drip, administered after the 2007/08 economic crisis are also, as yet, unknown.
Away from the economy, political tensions between Russia and the West are arguably at their lowest ebb since the Cold War, while President Trump remains a constant source of uncertainty. Closer to home, Theresa May’s government continues to look weak, making the prospect of a hard-left administration far less fanciful than it was 12 months ago.
And we haven’t even mentioned Brexit.
Any one of these things, or a combination, or something entirely unrelated which nobody has seen coming, has the potential to breed doubt and send the global economy into a tailspin.
Equally, markets could saunter on their merry way for a while longer yet.
The point is we don’t know. But if history tells us anything it’s that, at some point, what has gone up will eventually come down, potentially very quickly.
Pound cost ravaging
While such potentially dramatic portfolio dips are less of a problem during accumulation – when there is time for the fund to recover and the client is contributing rather than taking money out – in the early years of drawdown it could spell retirement disaster.
This is particularly the case when negative returns are combined with large withdrawals. And with withdrawals now unrestricted from age 55, the potential for retirement harm has never been greater.
To illustrate this, let’s use some actual data – namely the FTSE All Share, which has delivered an annualised total return (including dividends) of 9.48% over the past 25 years. That would have turned a £100,000 pension pot into £565,000 if no withdrawals were made (assuming a total charge of 1%).
If a 65-year-old with a £100,000 pot had made withdrawals of £10,000 a year over this period, they would have run out of money last year – at age 90.
However, to illustrate the impact so-called ‘pound cost ravaging’ can have, let’s make one simple change. If you swap the first year (1993 – when markets rose by over 28%) with the year where performance was worst (2008 – when markets dropped by almost 30%), our 65-year-old runs out of money at age 75 – some 15 years sooner.
To put it another way, one unfortunate twist of fate cost our saver £150,000 in retirement income (see graph).
Of course, this has become a much bigger issue since former Chancellor George Osborne’s shock reforms ripped up the retirement rulebook just over three years ago.
Indeed, the FCA’s Retirement Outcomes Review interim report published in July last year focused on, among other things, protecting savers who may not engage with their drawdown pot in retirement (and so risk taking out too much or failing to implement a drawdown-appropriate investment strategy – or both).
While the review has (for now) steered clear of forcing providers to offer default drawdown withdrawal rates – as some have called for – it has floated the idea of creating default investment pathways to guide savers towards suitable strategies.
It is not yet certain the FCA will run with this idea or how it would work in practice, but reducing the likelihood of non-advised savers sleepwalking into pound cost ravaging is undoubtedly close to the front of the regulator’s mind.
The value of advice
For advisers and clients, the aim of the game is risk mitigation. At a TISA seminar not too long ago, the late Malcolm Small – a man whose views I hugely respected – floated the idea that it might be appropriate to take more stock market risk in retirement. The logic he laid out was that, with a large fund on the table, this was exactly the wrong moment to take investment risk off the table as you’d be getting a bigger nominal bang for your percentage growth buck.
Pound cost ravaging is the counter to this argument. Ultimately keeping a significant amount of equity risk in a client’s portfolio provides both greater upside and greater downside potential in retirement.
Finalytic’s Abraham Okusanya and others have done an excellent job of highlighting this issue, which is increasingly becoming a central part of any retirement planning strategy.
Furthermore, it is an area where the value of regulated financial advice is pretty obvious. Although some commentators will continue to pine for product “innovation” to help people make the most of drawdown, I have yet to see a coherent explanation of what this should look like. For those who choose drawdown, complexity and risk are inherent, and engagement and regular reviews absolutely essential.
In such an environment, getting the right professional help could save people from making a seriously costly mistake.
Tom Selby is senior analyst at AJ Bell