Turmoil in the markets imperils pensions

While falling share prices can be a buying opportunity for younger investors, people no longer earning a living are investing irreplaceable capital. That makes retirement a bad time to discover the dangers of stock markets, or how events in faraway places such as Beijing or Shanghai can have nasty cash effects closer to home.

But it’s an ill wind that blows nobody any good and investors who have yet to retire may consider it is worth buying shares tomorrow for substantially less than they would have cost a week ago. Whatever else investors do, they should avoid the temptation to sell after setbacks because history shows that the biggest gains often occur immediately after a crisis.

For example, the stock market delivered average annual returns of 7% to investors who remained invested throughout the last decade but, according to the fund manager Fidelity, anyone who missed the best 10 days of that period saw returns collapse to less than 1%. To gain from stock market volatility, you have got to be in it to win it.

Devaluation of the yuan sparked a global stock market sell-off and it remains unclear whether the pessimists or bargain-hunters will be proved right. Last week’s interest-rate cut by the People’s Bank of China — the fifth since November — failed to allay fears that lower money costs may prove as ineffectual as pushing on a piece of string.

While share prices struggled to regain some ground last week, critics claim that income drawdown could turn a short-term setback into a long-term pensions disaster. One director of a big financial institution, who asked not to be named, said: “We are not sure everyone understands the fundamental risk of this new freedom of choice — that your savings might expire before you do.”

Worse still for pensioners who opted for income drawdown, or approved retirement funds in Ireland, losses suffered in the early years of retirement may prove difficult to recover.

As I pointed out in The Sunday Times in January, pensioners who encash units or shares from falling funds are eating up their seed corn and reducing their exposure to any future upturn that may arise.

I reported calculations by Cazalet Consulting showing how anyone who invested £100,000 (€137,000) in the FTSE All-Share (the index that includes the FTSE 100, 250 and Small Cap) at the start of this century and withdrew an annual income of £10,000 would have run out of money by 2008. The sequence of events also matters.

Take the example of two pensioners, each with a £100,000 fund that sees an average annual return of 7% over a decade. If the first suffers losses in the early years and the other later, the first could end the period with less than £72,000, while the second could have more than £120,000. As I wrote in January: “The explanation is that if you suffer a loss of 20% on £10,000, reducing it to £8,000, you need a gain of 25% — or £2,000 — to get back to where you started. If you lose 25%, you need to win 33% to claw back to evens. Lest this sounds somewhat hypothetical, remember the FTSE 100 has fallen by about 50% twice since the start of this century.”

The first 50% fall was in 2003 in the run-up to the Iraq War, and the second was the financial crisis in 2009. That is why the first question anyone considering income drawdown should ask themselves is: “How would you feel if you lost half your life savings?” But paper losses created by falling share prices are not the same as real ones unless you sell.

No wonder leading advisers stress the importance of income drawdown investors retaining sufficient cash to see them through without having to sell shares or units at bargain-basement prices.

Darius McDermott of Chelsea Financial Services said: “Having a cash buffer equal to at least one year’s expenditure, preferably two, would be sensible. As we have been reminded, stock markets can take a pounding, so you need to be able to ride out these periods. For the same reason, I think you need a bare minimum of £250,000 at retirement before considering income drawdown.”

Alan Steel of Alan Steel Asset Management pointed out the earliest drawdown schemes were marketed by Equitable Life in the 1990s before that insurer nearly went bust. He said: “The drawback to drawdown is that unless your portfolio is diversified into safety — not having all your eggs in one basket — you can suffer hugely when share prices fall.

“Drawdown is a long-term commitment and these pensioners need long-term skilled care. Personally, I don’t see much of that about. Drawdown in the wrong hands is dangerous. Let’s hope pensioners don’t stick their money in schemes with high charges and low cash reserves and the rest bunged into passive funds — or stock market trackers — so their adviser gets an easy life.”

A mix-and-match approach, using annuities or cash to fund essential spending and income drawdown for “nice but not necessary” things, would be wise. Otherwise, unintended consequences of pensions freedom could cause the same regret that Joplin felt for Bobby McGee — but without the wild-eyed affection.

Freedom is just another word for nothing left to lose — or so sang Janis Joplin when many of today’s pensioners were hipsters the first time round. But some of those who exercised the financial freedoms for pensioners may recall the ill-fated singer’s plaintive ballad, Me and Bobby McGee.

The freedoms, introduced here in 1999 and Britain last year, gave every pensioner the right to choose to leave their life savings invested in the stock market after retirement. But it is vital to be aware of the risks involved, which the terrifying performance of stock markets around the world over the past few days and weeks has amply demonstrated.

“The Great Fall of China” was a great headline. But do you have the nerve to be a customer on this rollercoaster?

While falling share prices can be a buying opportunity for younger investors, people no longer earning a living are investing irreplaceable capital. That makes retirement a bad time to discover the dangers of stock markets, or how events in faraway places such as Beijing or Shanghai can have nasty cash effects closer to home.

But it’s an ill wind that blows nobody any good and investors who have yet to retire may consider it is worth buying shares tomorrow for substantially less than they would have cost a week ago. Whatever else investors do, they should avoid the temptation to sell after setbacks because history shows that the biggest gains often occur immediately after a crisis.

For example, the stock market delivered average annual returns of 7% to investors who remained invested throughout the last decade but, according to the fund manager Fidelity, anyone who missed the best 10 days of that period saw returns collapse to less than 1%. To gain from stock market volatility, you have got to be in it to win it.

Devaluation of the yuan sparked a global stock market sell-off and it remains unclear whether the pessimists or bargain-hunters will be proved right. Last week’s interest-rate cut by the People’s Bank of China — the fifth since November — failed to allay fears that lower money costs may prove as ineffectual as pushing on a piece of string.

While share prices struggled to regain some ground last week, critics claim that income drawdown could turn a short-term setback into a long-term pensions disaster. One director of a big financial institution, who asked not to be named, said: “We are not sure everyone understands the fundamental risk of this new freedom of choice — that your savings might expire before you do.”

Worse still for pensioners who opted for income drawdown, or approved retirement funds in Ireland, losses suffered in the early years of retirement may prove difficult to recover.

As I pointed out in The Sunday Times in January, pensioners who encash units or shares from falling funds are eating up their seed corn and reducing their exposure to any future upturn that may arise.

I reported calculations by Cazalet Consulting showing how anyone who invested £100,000 (€137,000) in the FTSE All-Share (the index that includes the FTSE 100, 250 and Small Cap) at the start of this century and withdrew an annual income of £10,000 would have run out of money by 2008. The sequence of events also matters.

Take the example of two pensioners, each with a £100,000 fund that sees an average annual return of 7% over a decade. If the first suffers losses in the early years and the other later, the first could end the period with less than £72,000, while the second could have more than £120,000. As I wrote in January: “The explanation is that if you suffer a loss of 20% on £10,000, reducing it to £8,000, you need a gain of 25% — or £2,000 — to get back to where you started. If you lose 25%, you need to win 33% to claw back to evens. Lest this sounds somewhat hypothetical, remember the FTSE 100 has fallen by about 50% twice since the start of this century.”

The first 50% fall was in 2003 in the run-up to the Iraq War, and the second was the financial crisis in 2009. That is why the first question anyone considering income drawdown should ask themselves is: “How would you feel if you lost half your life savings?” But paper losses created by falling share prices are not the same as real ones unless you sell.

No wonder leading advisers stress the importance of income drawdown investors retaining sufficient cash to see them through without having to sell shares or units at bargain-basement prices.

Darius McDermott of Chelsea Financial Services said: “Having a cash buffer equal to at least one year’s expenditure, preferably two, would be sensible. As we have been reminded, stock markets can take a pounding, so you need to be able to ride out these periods. For the same reason, I think you need a bare minimum of £250,000 at retirement before considering income drawdown.”

Alan Steel of Alan Steel Asset Management pointed out the earliest drawdown schemes were marketed by Equitable Life in the 1990s before that insurer nearly went bust. He said: “The drawback to drawdown is that unless your portfolio is diversified into safety — not having all your eggs in one basket — you can suffer hugely when share prices fall.

“Drawdown is a long-term commitment and these pensioners need long-term skilled care. Personally, I don’t see much of that about. Drawdown in the wrong hands is dangerous. Let’s hope pensioners don’t stick their money in schemes with high charges and low cash reserves and the rest bunged into passive funds — or stock market trackers — so their adviser gets an easy life.”

A mix-and-match approach, using annuities or cash to fund essential spending and income drawdown for “nice but not necessary” things, would be wise. Otherwise, unintended consequences of pensions freedom could cause the same regret that Joplin felt for Bobby McGee — but without the wild-eyed affection.