Beware the dangers of 'pound cost ravaging'

With the introduction of pension flexibility, one of the biggest dangers to people's retirement pots is the impact of so-called "pound-cost ravaging". The term describes the negative effect of over-ambitious regular withdrawals if they are made after markets have fallen.

"I explain to my clients that for them to have the retirement they want and need, the sustainability of their fund is key," says Peter Savage, chartered financial planner at Fairstone.

Let's consider the example of a person who retired in 2007 compared with someone who retired in 2009. Both retirees are starting out with a £100,000 pension pot, and take annual withdrawals of £5,000.

In both cases, the £100,000 is invested in the average mixed asset fund (Investment Association Mixed Investment 40-85 sector), with 5% annual withdrawals taken monthly.

Pound-cost ravaging

For the "2007 retiree", the time period used in this example was 11 October 2007 to 11 October 2012, and for the "2009 retiree" it was 6 March 2009 to 6 March 2014, using data provided by Old Mutual Wealth and FE Analytics.

After five years the 2007 retiree will have around £79,561 in the pot and the 2009 retiree will have around £153,292 in the pot.

"When people retire they assume a steady rate of return in their retirement projections, but this doesn't take into consideration the fact that the market doesn't provide steady consistent returns," says Savage.

The importance of diversification

When people keep taking a fixed withdrawal while the market and their underlying investments fall, more units have to be sold in order to cover the amount of income taken. With progressively fewer units in the pot, it becomes more difficult for the pension pot to recover.

So what can be done to mitigate this? Diversification is crucial, says Savage. "Look at having a good mix of assets such as shares, bonds, property, commodities and alternatives. What you don't want are assets that are very correlated."

A natural income withdrawal will not eat away at the existing number of unitsHe points out that people should to draw on the natural income the portfolio generates, rather than a fixed withdrawal.

A natural income withdrawal will not eat away at the existing number of units so, in the event of a fall in the fund/portfolio value, it can recover much more easily because units haven't been ravaged from the fund.

It is also worth holding a cash pot to fall back on for income in the event of a market slide, so that the pension fund has the best chance of recovery; natural income reinvested at that time will buy more additional units when they are relatively cheap.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.