How to deal with market crashes in retirement

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.

Back in the real world

This is just an illustration of the concept. To analyse how this might impact investors in the real world, we’ve applied the concept to actual market data.

To demonstrate the contrasting impact of early vs late losses, we selected a 20-year period from the end of 2005 until the end of last month.

We chose this period deliberately. Using the actual market data for this period, we can see the impact of early losses on a drawdown pension pot. An unlucky investor who retired at the end of 2005 would have soon been living through the great financial crisis of 2008-9. Their portfolio would undoubtedly have suffered some heavy early losses, although markets have subsequently recovered strongly.

To illustrate the opposite scenario of early gains and later losses, we simply reversed the order of returns, as can be seen in the chart here and in the numbers below:

Here are the assumptions we made in creating this model:

• A £1m pension pot at the end of 2005
• Market returns are those of the MSCI World index, with income reinvested to give the total return (capital plus income)
• An income of £4,000 a month is taken quarterly throughout the period (in line with recent revision of the ‘4% rule’ which suggest this could be a safe level of income withdrawal). We have escalated the income at 2% a year to counter the impact of inflation

First, let’s see what the impact of the sequence of returns was.

Fully invested - unlucky timing

Investor A was fully invested in the stock market throughout.

The end result for this investor might not seem too bad. Especially when you consider that by the end of the period, they are withdrawing an income of nearly £6,000 a month.

However, it was a hairy ride early on. Just three years into retirement this investor was looking at a more than 40% reduction in the value of their pension pot. This would have tested anyone’s faith in the market.

Let’s compare this scenario with the opposite situation in which the same returns were experienced but in the reverse order.

Fully invested - favourable returns sequence

Investor B:

They never ate much into their starting capital. And at the high-water mark, they were well ahead. The losses towards the end of the period would have been hard to stomach, but this investor was well cushioned and would never have worried about running out of money.

Navigating the storm

Next, let’s look at what an investor might try to do to mitigate the impact of early falls in the market. Intuitively, a cash buffer would seem to make sense. It reduces exposure to the market during the downturn and so reduces losses. Increasing the proportion of cash in a portfolio is what investors often reach for first when markets become choppy.

First, we tested the experience of an investor who kept three years of income in cash at the outset and simply sat on that cash pile throughout. That’s £144,000 in this example (three times £48,000 a year). The remaining £856,000 is invested in the same MSCI World index, with income reinvested.

We assumed that the investor earned 4% on their cash - too high for much of this period but realistic today.

Cash cushion

Here’s how things turned out for Investor C:

Going partially into cash did smooth the journey to an extent. The low point was £59,000 higher than for the fully invested Investor A, but that peace of mind came at a cost. By parking a proportion of the portfolio in relative low yielding cash throughout the 20-year period, the end value was £420,000 lower.

As a matter of arithmetic, the greater the cash buffer used in this scenario, the greater the downside protection but also the higher the cost of the security blanket. Investor D went further and set aside five years’ worth of income (£240,000). Their outcome is shown below:

Here is how the three scenarios look over the 20-year period.

Getting more hands on

Clearly, using a cash buffer for peace of mind comes at a cost. So, we explored if there is a more sophisticated way of using that cash pile to reduce the drag.

The benefit of holding cash in a portfolio is that you have two options about where to take your quarterly income from. You can take it straight out of investments. Or you can take it out of your cash reserve and wait for the market to recover before once again dipping into your investments.

If your cash buffer is large enough, the theory is that you can ride out most, if not all, of the downturns that you are likely to experience during your investing lifetime.

To test this, we created a rules-based system for managing the flow of money between investments and cash buffer and back again. In the first scenario, we applied the following rules:

1. We started with a three-year cash buffer (£144,000). The remaining £856,000 was invested in the MSCI World index, with income reinvested.

2. At the start of each quarter, we took three months income out of cash (£12,000). This income rose each quarter by half of one percent (roughly 2% a year to counter inflation).

3. We then checked the performance of the market in the previous quarter.

   1. If the market had risen, or fallen by less than 10%, or if our cash buffer had fallen below a year’s worth of income, we transferred the amount we had taken as income from our investments to the cash buffer.

   2. Otherwise, we deferred the transfer and made a note that our cash buffer was ‘owed’ that money from the investments, to be paid later when market conditions had improved.

4. Finally, we made a second decision - whether or not to start rebuilding our cash buffer to repair previous deferrals. Rather than looking at just the performance of the market over the past quarter, we took a longer view with this decision, checking how the level of the market compared with two years previously.
   1. If the market was higher than two years earlier or if our cash buffer had simply run below that one year minimum, we added back a further three months’ worth of income (in addition to any money we had taken for immediate spending) until we had made good all the accrued deferrals.
   2. Otherwise, we held off and waited for better times.

The advantage of this approach is its relative simplicity. Just four decision points a year, with two decisions every three months, and no subjective judgement required. Just the discipline to do what the rules tell us to.

Did it work?

Yes, to an extent. Here is the outcome for Investor E who adopts the strategy: 

The low point is similar to the investor who sought protection by simply sheltering a proportion of their pension pot in cash but the end capital is significantly higher - £1.42m vs £1.29m.

We wondered whether a focus on short term quarterly returns might be unhelpful, so we also looked at using a two-year trigger instead.

We only took income out of investments if the market had risen over two years or fallen by less than 10% over that period. Here are the numbers for Investor F:

So, only a marginal improvement on the quarterly performance check used by Investor E.

Finally, we wondered if we were pulling the trigger too quickly, and so we adjusted the cut off to a fall of 15% rather than 10% over the prior two years. This made almost no difference either.

As you can see from this final chart, there is a material advantage in avoiding income withdrawals after market falls, but it does not compensate for the cost of holding a material amount of your pension pot in cash and so out of the market.

Conclusion

This exercise told us a few things:

1. Sequencing risk is very powerful and there is no simple way of mitigating it. If you are unlucky with the sequence of your returns, it is difficult to overcome the negative impact on your portfolio.
2. You can reduce the volatility of your investments by holding more cash, but this comes at a cost. You can smooth the ups and downs of your portfolio, but you will probably have to accept lower longer-term returns. Only you can decide where your tolerance for volatility lies.
3. However, managing your withdrawals according to the level of the market can reduce the drag caused by holding cash. You can make your cash pile work for you rather than simply sitting there idly.
4. The more cash you hold, the longer you can put off dipping into your investments, and this can increase the size of your pension pot if markets recover over time from early falls. But in a prolonged bear market such as we experienced in 2008/9 you will run down your cash buffer quite quickly.
5. The more guaranteed income you enjoy (perhaps through a final salary pension or the state pension) or can create (perhaps by purchasing an annuity), the less you will worry about the ups and downs of the market and the more likely it will be that you will stick to your retirement income plan.

For that reason, if like many of us you don’t enjoy a final salary pension, it might make sense to consider covering your essential expenditure with an annuity. Knowing that whatever happens in the market you will be able to pay the bills and keep a roof over your head is priceless - and will become more so the older you are.

Having a guaranteed income covering the basics will allow you to calmly wait for the market to recover any short-term losses. And crucially it will allow you to be fully exposed to the long-run outperformance of the stock market, which compounded over many years is the most powerful force determining your financial security in retirement.

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.ukor over the telephone on 0800 011 3797.

Fidelity’s retirement specialists can provide you with free guidance to help you with your decisions. Our advisers use cash-flow modelling tools to help you plot a sustainable - but optimised - plan for income in retirement. 

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: Deferring your state pension. Good or bad idea?
• Read: What income might I get from a £500,000 pension?
• Read: Why you don’t get the full State Pension