How to avoid running out of money in retirement

Posted by Olderiswiser Editorial

Nathan Long looks at 'capital nibbling' and other investment strategies as a means of generating retirement income.

retirement income

New research from Hargreaves Lansdown shows the devastating impact of drawing too much income in retirement. Analysis of returns from the FTSE All Share since the turn of the Millennium shows;

  • Drawing at 5% every year from January 2000 would leave you with just less than half of your pot left.
  • Drawing 6% per year would mean you will run out of money before 2020
  • Drawing 7% per year means your money ran out back in 2014
  • Drawing the natural yield means both income and capital have grown

Low annuity rates have seen retirees turn their back on secure income, instead the industry has seen a preference for a ‘capital nibbling’ approach where investors regularly sell their investments to fund their retirement income. This approach can work in strong stockmarket conditions such as those experienced following the introduction of the pension freedoms, but you do not want to be a forced seller of investments when the market falls.

The alternative to capital nibbling is drawing the natural yield which is a sustainable way of drawing from your pension where you take only the income produced by your investments. This is effective because whilst dividends can fluctuate they are far less volatile than share prices as they are driven by company fundamentals as opposed to sentiment. From the turn of the millennium, being invested in the FTSE All Share would twice have lost over a third of your pension value in a 12 month period. However, the level of income received was far more robust materially falling only once from one calendar year to the next.

With plenty of equity income funds yielding over £4000 for £100,000 invested, this is an option which could suit many people who do not want to buy secure income.

Capital Nibbling vs Natural Yield £100,000 Invested

Start Date: January 2000

 

Initial Income

Income Now

Cumulative Income Received

Capital Value Now

Total Return

(Income + Capital)

Lowest Fund Value During Period

Capital Nibbling

FTSE All Share £5k p/a

£5,000

£5,000

£88,334

£45,433

£133,767

£38,514

Capital Nibbling FTSE All Share £6k p/a

£6,000

£6,000

£106,000

£9,569

£115,569

£9,569

Capital Nibbling FTSE All Share £7k p/a

£7,000

£0

£101,316

Money runs out 31/05/2014

£101,316

£0

Natural Yield FTSE All Share

£2,052

£4,146 (full year 2016)

£52,069

£124,803

£176,872

£58,411

Source: Hargreaves Lansdown, LIPPER, based on a £100,000 pension pot, income commencing 1st January 2000, FTSE All Share – no charges.

Pension pot size over time when funding retirement income by selling investments – what we call capital nibbling.

Pension pot size - capital nibbling

Current Income Options

When it comes to the options facing retirees currently, we can see that natural yield income looks an attractive alternative.

Option

Income from a £100,000 pension

Single Life, Level Annuity at 65 with 5 Year Guarantee

£5,209

Single Life, RPI Linked Annuity at 65 with 5 Year Guarantee

£3,242

Natural Yield FTSE All Share *

£3,620

Natural Yield - Average IA UK Equity Income Sector

£4,180 (range 2.72% to 7.03%)

*Source Bloomberg – 19th October 2017

Natural yield and why use it

Natural yield is a sustainable way of drawing from your pension, where you take only the income produced by your investments.

The challenge when drawing down from your pension is that you not only have to select where to invest, you need to select an appropriate level of income to draw. Pension providers will struggle to solve this problem with default drawdown solutions, as the amount of income you opt to draw is likely to change the investment mix you should choose for your pension.

Natural yield provides sustainability of income as you are never nibbling away at your capital when the stockmarket falls which is where retirees run the risk of running out of money in retirement.

Income & capital fluctuations

The reason natural yield is so effective, is that whilst dividends can fluctuate they are far less volatile than share prices, provided you have a diversified portfolio. Dividends are dictated by a company’s underlying profitability, whereas share prices are determined by people’s sentiment towards owning shares and human beings have a tendency to not always act rationally. 

Looking at the FTSE All Share from the turn of the millennium, twice you would have lost over a third of your pension value in a 12 month period. However, the level of income received was far more robust. Income fell in 2009 by 11%, stabilised in 2010 before returning to a greater level than 2008 in 2011.

Fluctuating income from FTSE All Share

Fluctuating income from FTSE All Share

When natural yield is not enough

Some people will not have large enough pension pots to make the level of income payable from the natural yield enough to maintain the lifestyle they want.

There are ways to circumvent this problem. A level annuity bought at 65 will provide an income that is higher than the natural yield. In the same way that most people can benefit from a diversified portfolio when building up their pension, they can also benefit from diversification when drawing from their pension. Using your pension pot to buy some annuity for an instant boost to income with natural yield from drawdown from the remainder can be an excellent choice.

Many people also neglect the tax free lump sum as a source of income in retirement. Using the tax free lump to top up income from natural yield can be a useful strategy.

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