Many savers can afford to ride out the current market sell-off, but those about to retire and start living off their investments cannot necessarily wait for a recovery.
Markets have turned red as central bankers and politicians struggle to get soaring inflation under control and a recession looms, creating a gaping hole in many people’s retirement funds.
Unless you are lucky enough to have a generous final salary pension, you will be relying on your investments to fund your old age, either by drawing an income from them directly or converting your pot into an annuity.
Markets in the red: Many savers coming up to retirement are looking at gaping holes in their pension funds
This is Money’s pensions columnist, Steve Webb, recently replied to a reader whose pension fund had fallen £3,000 in value just as they were about to retire, and was desperate to freeze and cash it in before they racked up further losses.
His column drew a big response from commentators, many of whom had seen plunges in the value of their own funds, and from readers who wrote in to Webb’s inbox with questions about similar problems.
A development that might be exacerbating pension fund losses is that a lot of work schemes don’t automatically ‘derisk’ them in the 10-year run-up to retirement age any more.
This was the typical practice, known as ‘lifestyling’, when most people needed their funds to remain relatively stable before they bought an annuity, which locked in its value for good at retirement.
Now, most modern workplace pension schemes leave people nearing retirement in risky investments like stocks by default, on the assumption they will stay invested and draw down an income from them in retirement.
However, whether your pension was lifestyled or not might make little odds, because there are not really any ‘safe havens’ at the moment, according to financial planner Gary Smith of Tilney.
He points out that ‘derisking’ meant moving funds out of stocks and into supposedly safer fixed interest assets, like government and corporate bonds, but these have fallen in value too lately as central banks raise interest rates to combat inflation.
Financial experts have long feared a bond crash once central banks start to raise interest rates again, as they are doing at present.
This is because investors could decide they overbought bonds – both government and corporate – and dump them in a hurry.
So where does this leave savers staring at big investment losses, just as they plan to retire and starting tapping their pension pot? We look at what they might do to mitigate their plight below.
What are your options if your pension plummets just as you plan to retire?
Stay invested and hold on for recovery
‘If your pension fund has fallen near retirement, waiting for the fund to recover is the only option if you wish to recoup that loss,’ says Justin Modray, director of Candid Financial Advice.
He says this can be viable if you have other means of getting by such as savings, or you might consider working longer, perhaps part-time.
Modray also notes: ‘If you prefer the idea of keeping your pension invested and drawing an income, called “drawdown”, then you might be more relaxed about starting to draw an income now on the basis the monies that remain invested will hopefully recover in future.
‘Obviously there’s a balancing act between drawing enough income to live on and not taking too much that might thwart recovery prospects.’
Gary Smith, chartered financial planner at Tilney, says it is worth considering whether you have other assets to use up – cash savings, cash Isas, or NS&I products like premium bonds – to avoid drawing on investments and locking into a loss at the start of retirement.
‘It might be preferable to draw an income from these in the first year of retirement to allow your investments to potentially recover in value.
Why is pension drawdown popular?
Pension freedom reforms launched in 2015 give people the power to do what they want with their retirement savings after they reach the age of 55.
This has led to many staying invested and shunning annuities, which are poor value and restrictive but provide a guaranteed income until you die.
Opting for drawdown gives retirees more flexibility and the opportunity to keep growing their fund if they invest wisely, but they must be prepared to monitor their investments and shoulder financial market risks in their old age.
‘If you don’t have other assets and still intend to retire, look to draw down on a monthly basis not a lump sum.
‘For example, if you need £3,000 a month, don’t take out £36,000 and put it in the bank, locking in the full loss.
‘Lock in a loss on each £3,000, and if markets improve you aren’t looking at a full loss.’
But this assumes a near term recovery, and Smith attachs a warning, saying: ‘The risk is if markets continue to fall you lock in a bigger loss than if you had just taken a lump sum.’
Tom Selby, head of retirement policy at AJ Bell, says: ‘The later you are able to wait before accessing your pension, the greater annual income it will be able to deliver too.
‘Of course, if you need to access your pension to provide a retirement income that is what it’s there for – but it’s worth asking yourself the fundamental question.’
Consider what to do about your 25 per cent tax free lump sum
‘In order to draw income you need to “crystallise” the pension fund, which gives the option of taking up to 25 per cent as a tax-free cash lump sum,’ says Modray.
‘Whilst the tax-free cash is usually a good idea, consider crystallising just enough of the pension to provide income for the first year, rather than the whole lot, to leave more pension invested in the hope of recovery.’
Savers are not limited to just one chance to take a tax-free lump sum worth 25 per cent of their pension pots – instead they can benefit from the same chunk untaxed on multiple withdrawals.
Assuming you do not take your entire lump sum upfront, each chunk you take from the uncrystallised pot will be 25 per cent tax-free, and 75 per cent taxed at your marginal income tax rate.
You might hear this approach to withdrawals referred to ‘UFPLS’, which stands for ‘uncrystallised funds pension lump sum’.
Meanwhile, people who start tapping pots for any amount over and above their 25 per cent tax free lump sum are only able to put away £4,000 a year and still automatically qualify for tax relief from then onward.
The lower annual limit is known in financial jargon as the ‘money purchase annual allowance’ or MPAA.
Selby says: ‘Taking taxable income from your fund will reduce your annual allowance, the amount you can pay into your pension, from £40,000 to just £4,000.
Spend your pension pot last!
Financial experts say anyone who wants to minimise their annual income tax, or use up their capital gains tax allowance efficiently, might also benefit from running down assets held outside a pension first.
We reveal the order to use savings in retirement to defend your cash from the taxman.
‘This is important if you decide you want to make additional pension contributions in the future, as you won’t be able to benefit from tax relief on anything over £4,000 a year.’
And Selby adds: ‘The later you are able to wait before accessing your pension, the greater annual income it will be able to deliver too.
‘Because pensions benefit from generous tax treatment on death, it can make sense for this to be the last asset you touch.
Review your investments
‘If you plan to keep your fund invested via drawdown, it is possible that your investments won’t need to change at all,’ says Selby.
‘A healthy 65-year-old could live for 30 years or more in retirement – meaning their investments have plenty of time to grow even as they are taking an income.’
He says that for someone in this position, a bit of short-term market volatility of the kind we’ve seen recently shouldn’t be a major cause of concern.
But Selby adds: ‘You should also consider whether your investments are aligned to your retirement plans, both in terms of risk and what they are trying to achieve.
‘Given the aim of the game at this point is usually generating an income, picking stocks or funds aimed at producing a steady income is a common approach.’
Modray also advises reviewing your investments to ensuring they’re suitable for the level of risk you’re comfortable taking, and to generate an income in retirement if that is relevant.
‘However, if you’ve lost money due to high stock market exposure, switching to safer investments now might limit your recovery prospects in future, so is not a decision to be taken lightly,’ he cautions.
Gary Smith: If you buy an annuity now, it is a one-way street. If you do drawdown, you keep your options open
Put some of your pension fund into cash
You can shift some of your investments into cash within your pension fund, either before retirement or afterwards if you stay invested, and draw on that portion of your pot while waiting for financial markets to bounce back.
This will help you avoid a nasty trap called ‘pound cost ravaging’, which can do severe damage to pension investments, especially in the early years of retirement.
It means that when markets fall you suffer the triple whammy of falling capital value of the fund, further depletion due to the income you are taking out, and a drop in future income.
‘Large withdrawals in the early years of retirement combined with big market falls could have a seriously detrimental impact on the sustainability of your plans,’ says Selby.
‘This is one reason it’s important to keep your strategy under regular review – and be prepared to cut back if necessary.
‘If you’re going down this road you should consider shifting some of your investments into cash to pay your income. Usually anywhere between 12-24 months’ expenditure is about the right level.’
Smith says if you are planning to retire in a few years and expect markets to remain volatile, you could move some of your portfolio into cash well ahead of time.
In that way, you will protect that cash against further losses, and have enough ready to cover your likely expenditure during the first two years of retirement if you are still waiting for your investments to recover.
Buy an annuity
Pension freedom reforms in 2015 have prompted a lot more people to keep their funds invested and opt for income drawdown instead of buying annuities in retirement.
Annuities provide a guaranteed income for life, but are widely considered poor value for money and restrictive.
Justin Modray: If you’ve lost money due to high stock market exposure, switching to safer investments now might limit your recovery prospects in future
Smith says annuities are still appropriate for some retirees, but explains that they haven’t been attractive for many years because the yield from gilts – UK government bonds – has been low, and this has had a knock-on effect on annuity rates.
He says recent interest rate rises have improved gilt yields, and annuity rates have improved slightly but remain low, especially if you are in good health.
Smith says you will lock in an investment loss if you buy an annuity now, whereas if you stay invested and wait until you are older the rates might improve, and also as you age you are likely to get a better deal.
‘If you buy now, it is a one-way street. If you do drawdown, you keep your options open,’ he says. ‘Markets can recover, and annuity rates will be higher when you are older.’
Selby says: ‘If you are using your entire pot to buy an annuity, you should already have shifted your fund into cash.
If you haven’t, you should consider doing this – otherwise your retirement prospects will be a hostage to the fortune of short-term market movements.
‘There is no other way to “freeze” your pension pot and lock-in its value while it is still invested. While your fund is in the stock market it still has a chance to grow over the long-term, but in the short-term it could fluctuate in value significantly.’
He also reiterated Smith’s point above, saying: ‘If you do look at an annuity it’s worth remembering that the older you are, the better the annuity rate you will be able to get from an insurance company.’
To people sitting on a recent investment loss, Modray points out: ‘If you are keen to swap your pension for a fixed income for life via an annuity, then your pension income will be lower due to having less pension fund to buy the annuity.’
Cash out your pension investments
Taking your entire pot in cash can land you with a heavy tax bill, and potentially leave you without an income plan to fund a retirement that can last decades.
Surveys of retirees have revealed some have used pension freedoms to switch retirement savings into current accounts and let them get gobbled up by low interest rates and inflation.
Tom Selby: Large pension withdrawals in the early years of retirement combined with big market falls could have a seriously detrimental impact
This is frowned upon by financial experts, who warn your savings will just lose value, and you can miss out on bigger returns from staying invested in a pension or drawdown scheme.
Not touching pension money also keeps it shielded from the taxman, on anything taken out beyond your 25 per cent tax-free lump sum.
‘If you’re planning to cash in your entire fund then you should also be invested mostly in lower risk assets, again so you have a clear idea what you will get when you come to withdraw the money,’ says Selby.
But he warns: ‘Anyone going down this road also needs to consider the tax implications, as well as the sustainability of their withdrawal plan.’
What else should you consider if your pension fund is taking a hit
Separate your retirement into different ‘slots’ of time
You are likely to be more active and spend more in the earlier stages of retirement than you are later on, says Smith.
Your state pension, worth £9,700 a year if you qualify for the full flat rate, will kick in at 66.
You might therefore be able to afford to withdraw higher pension investments if you retire before that, knowing you will require lower sums once your state pension starts, suggests Smith.
Meanwhile, he notes you might be able to draw on other assets in later life if you have them, for example downsizing your property, doing equity release, receiving an inheritance, and using other assets like buy to let property and Isas.
Make sure your pension withdrawal plans are tax efficient
Arrange to take the income you need in retirement in a tax efficient manner, by drawing on Isas and making sure your fully utilise your annual personal allowance of £12,570, says Smith.
‘Married couples can build quite a tax efficient income in retirement, locking in a lower rate of loss and not withdrawing money simply to pay income tax with it,’ he adds.