Black Monday highlights risks for retired investors
Retired investors are being warned that taking capital out of their pensions during falling markets could cause irreparable damage to their financial security.
On Monday 24 August the FTSE 100 lost close to 5% as concerns over China's struggling economy led to one of the biggest global stockmarket sell-offs since Lehman Brothers collapsed in 2008. Experts reckon global markets lost a total of $1.6 trillion on that day.
Danny Cox, head of financial planning at Hargreaves Lansdown, said: "Falling markets can have a significant impact on those drawing capital from their pension plans at retirement. If you draw capital when markets fall, you run an increased risk of rapidly eroding your pension and running out of money. You are locking in losses and can suffer irreparable damage."
Navigate choppy markets
However, Cox said it was important to appreciate the difference between drawing capital and investment income out of a pension. The former involves selling assets to fund the withdrawal while the latter only takes the gains made by your assets and your underlying capital remains intact. Advisers call this taking the 'natural yield' of your investment.
He added: "Investors who stick to a strategy of taking the natural yield, or even no income at all, can better navigate choppy markets."
Although market volatility can give retirees sleepless nights, Cox said there are plenty of steps savvy investors can take to protect their funds.
In addition to limiting withdrawals, Cox said investors should also keep a sizeable chunk of their pension in cash. "Keep at least one year's income – preferably two –in your pension plan, which will serve as a useful buffer during extreme markets. Drawing cash is unaffected by market movements and this account can be topped up by income generated from investments – such as dividends from shares or yields from bonds."
Ensuring you have a high level of diversification in your portfolio is also important. Cox said: "A diverse and balanced portfolio which has a mixture of different investment assets – cash, fixed interest and shares – is likely to be better protected during market falls and provide more consistent performance."
Finally, if you have savings you can take advantage of tax relief on contributions and pay more money into your pension. This means an injection of £2,880 will be boosted by £720 tax relief, giving you a total contribution of £3,600 for a non-earner.
Cox explained: "Add this into your pension pot when markets are lower and this will help the drawdown plan make up lost ground as markets pick up. If you have earnings, you can pay in more but remember those who are drawing income flexibly via drawdown effectively have their contributions to Sipps and other money purchase pensions capped at £10,000."
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The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.