Will Pound Cost Ravaging spoil your retirement plans? – Part 2

Last week I described Pound Cost Ravaging, and how it affects what you can safely withdraw from your retirement portfolio. I also showed how sequence risk can result in a big difference to the final value of your portfolio.

Stopping work is an enormous change, and many clients worry about how they will cope when their earned income comes to an end. It is difficult to make this adjustment, and watching your retirement income portfolio fluctuate in value in the first few years of retirement adds to the stress. Falls in the value of your retirement savings naturally lead to questions about whether you will outlive your retirement savings.

The nub of the question is whether ongoing withdrawals will deplete the retirement portfolio too much before the “good” returns finally show up.

Research into sequence risk tells us that:

  • The inflation adjusted returns in the first ten years of retirement is closely linked to the amount of money you can withdraw from your pensions and retirement savings. Inflation is just as important as investment returns – the impact of high returns can be nullified by high inflation, which results in your withdrawals needing to increase.
  • Investments don’t produce fixed annual returns, so the use of fixed growth rates in retirement forecasting is misleading. The fixed returns which are shown in many retirement forecasts result in poor predictions of how much you can (or should) take out of your retirement portfolio every year.
  • Your exposure to the risk of Pound Cost Ravaging is at its highest in the ten years immediately following your retirement.

Interestingly, research into sequence risk shows that there is almost no relationship between thirty year returns and the withdrawals that can be sustained by a portfolio. Surprisingly, the research into sequence risk shows that there is almost no relationship between returns in the first year or two of retirement, and the withdrawals that can be sustained by the portfolio… even if retirement starts out with a market crash.

Instead, it turns out that the true driver of sequence of return risk is the real (i.e. inflation adjusted) returns that the retiree earns from the portfolio over the first decade. The first decade will provide an indication of whether the retirement portfolio will have produced enough real growth to keep up with your spending for the rest of your retirement. If you retired in 2011 or 2012, you’ve had a great start, unless you kept all of your money in the bank!

This suggests that it is wrong to worry about returns in the immediate aftermath of retirement and that you should give your retirement portfolio an objective of producing higher returns than inflation for the first ten years of your retirement. Of course, that is easier said than done, but it suggests that it makes sense to include a large allocation to investments which can beat inflation in your retirement portfolio, when you stop work.

Philip Wise | philip@sussexretirement.co.uk

Managing Director and Chartered Financial Planner

This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The value of investments may go down as well as up and you may get back less than you invest.
Past performance is not a reliable indicator of future performance.
A pension is a long-term investment, the value of your investment and the income from it may go down as well as up. Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation.

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