In retirement, volatility is the price of better returns

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest.

The stock market fell by 40% in the year after the Arab oil embargo was lifted, as the economic chickens came home to roost.

A repeat of that period would be a problem for everyone, but it would be a particular challenge for someone coming to the end of their career and starting to think about taking an income from the money that they had saved up over their working life. Yes, I know, it’s all about me.

The issue of a market downturn in early retirement is called ‘sequencing risk’. It refers to the way in which the same set of annual investment returns can have a vastly different impact on your retirement, depending on the order in which they occur.

Two investors drawing an income from their pension pots can end up with two very different amounts of money, if they experience the same annual returns but in a different sequence.

An investor who starts their retirement with a few bad years in the market will have a much worse outcome than one who starts with a few good ones, even if the performances are subsequently reversed. ‘Bad then good’ is much more damaging than ‘good then bad’ when you are simultaneously taking money out of your savings to live on.

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I think of it like a bathtub. While the taps are open (you are paying into your pension), the tub fills quickly. The effect is pronounced if the market is rising at the same time. It is as if Mr Market comes along and pours extra buckets of water into the bath even while you’re filling it from the taps.

Once you retire, however, the taps are switched off (no more pension contributions) and you pull the plug out a bit too (you take an income). If, instead of adding bucketloads of water, Mr Market comes along and scoops some out (the market falls), you can see how quickly the tub might empty out.

You don’t have to go back to the 1970s to test this with actual market data. I turned the clock back 20 years to model a similar scenario - a class of 2005 retiree who had the misfortune to start drawing an income from their pension pot a couple of years before the financial crisis wiped away half of the value of the stock market.

I assumed the following: a £1m pension pot, £3,000 a month income (3.6% of the starting pot), taken quarterly and growing at 2% a year to keep up with inflation. For the sake of simplicity, I assumed the  money was invested in a fund tracking the MSCI World index from December 2005 to March 2026. This is just an illustration.

How did it work out? Not so bad, actually. Even with a string of quarterly losses in the early years, the modest withdrawal rate and the subsequent market recovery left the 2005 retiree with a pension pot worth £1.2m by the end of last month.

But it was a hairy ride. By March 2009, the £1m starting pot was worth just £560,000. Sticking with it, and avoiding the temptation to bail out and buy an annuity with what little remained at that point, would have been a stiff test of anyone’s faith in the stock market’s superior long-term returns.

To understand the devastating impact of those early losses, I simply reversed the sequence of returns over the whole 20-year period. In this parallel universe, when the losses came towards the end rather than the beginning, the starting £1m turned into £1.8m. The pot only dipped below the starting value in one quarter over the whole two decades. Same returns, different sequence, completely different outcome.

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So, what could this unlucky investor have done to minimise the damage? And what, therefore, might someone do today to avoid a similar outcome? A couple of things, but neither are a silver bullet, I’m afraid.

First, they could have reduced their exposure to the market by simply holding a proportion of their pot in cash or a similarly low-risk asset. I modelled this, assuming a 4% return on this part of the portfolio (unrealistic in the 20 years after 2005 but possible today). Sitting on five years’ spending in cash (£180,000 to start with) reduced the low point of the pot to above £600,000, but sleeping at night came at a significant cost. The end portfolio was not £1.2m but just over £1m.

Secondly, they could have put the cash to work by systematically taking income out of the cash pile when markets were depressed and replenishing the cash reserve only when the market recovered. I looked at a few different ways of doing this and I was surprised at how little impact this tinkering had. It added about £50,000 over the 20 years. Perhaps this is not surprising. The withdrawals are small in terms of the overall pot. Avoiding being a forced seller at market lows is helpful at the margin but it is not a game-changer.

The reality is that anyone going into pension drawdown is at the mercy of how the market cards are dealt. You can smooth the journey a bit, but ultimately you have to accept volatility as the price of better returns. You have to have faith that it will come right in the end and hope, above all, that your good years come before your bad ones. A good way of underpinning that leap of faith, and this is where I’m leaning, is to buy an annuity to cover the essentials and go all in on the stock market with the remainder.

The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

This article was originally published in The Telegraph.

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