A look at how to make the most of your pension pots and other investments to generate a decent retirement income.
Following the arrival of the pension freedoms in 2015, for most people, their retirement income can be made up from many different strands. There’s the state pension plus possibly some regular income through annuities and maybe income from investments and savings. Many, too, leave their pension pots invested through drawdown and look to take withdrawals from that.
For the latter and for those drawing income from their investments, there is the perennial question – how can I take an income from my drawdown pension or investment fund whilst ensuring that the withdrawals are sustainable?
Obviously, what is sustainable will vary from person to person. For those with a decent defined benefit pension scheme or two behind them, they might feel more comfortable making large withdrawals from their drawdown pension pot. However, for those relying on their drawdown pension pot for their income in retirement, they will need to be more circumspect in how they take income withdrawals, to ensure they don’t run down their pension pot too quickly.
When it comes to taking withdrawals from your drawdown pension or investment funds, there are two main approaches – ‘natural yield’ and ‘total return’.
Below we look at the two options to help you decide what might be the best route for you – but in reality, it may not be as simple as that as there may not be a single ‘right way’ to come up with your optimum retirement income strategy.
Natural yield – the rationale
This approach has been propounded for decades. The natural yield approach is based on preserving your investments and allowing them to generate income for you. This could be dividends from equities, the coupons paid from bonds or interest on cash. This approach appeals to those who believe that selling principal will reduce the longevity of their portfolio and prefer the discipline of living off portfolio income rather than determining a sustainable amount to withdraw from it.
Many investors are attracted to this approach. By not selling any of your principal, it means your capital has the opportunity to continue to grow and you won’t be in the situation where you need to make withdrawals during falling markets, which can make it more difficult to recover in the future.
In theory therefore, this approach gives your pension pot a better chance of surviving any downturns and the chances of making it last throughout retirement are increased. This could be useful for any future long-term care needs or to leave to your family or other dependents.
This latter option is particularly attractive following the pension freedoms introduced in April 2015 which changed the tax treatment of pensions on death. These new rules allow undrawn defined contribution pots to be passed on to your beneficiaries tax-free if you die before age 75, or at their recipient’s marginal rate of income tax after 75.
Whilst the theory is good, in practice, a natural yield approach can sometimes run into problems. For those who need to rely on a fixed level of monthly income to fund their day-to-day lifestyles (and some additional luxuries) in retirement, relying on the natural yield is not ideal. Yields vary, as we saw with last year’s dividend cuts. And in low-yield scenarios coupled with bond coupons hitting new lows, the hunt for reliable income has become ever more difficult. With this uncertainty, some may find that the natural yield approach might not be enough or is too irregular to fund their retirement needs.
Periods of low yields also tempt some to increase the risk in their portfolio by looking at higher-yielding stocks and corporate bonds. Whilst it makes sense to review your investments on a regular basis, there are obviously dangers in taking on board extra risk, as performance is not guaranteed and anticipated dividends or coupons could fail to materialise.
In summary, the natural yield approach can lead to a bias for securities that pay interest and dividends. Even if generating cash is your top priority, investors should carefully consider the investment trade-offs in pursuing an income-based strategy, as your income bias may affect your diversification and expected returns.
Total return – the solution?
In order to generate the required income without taking on unwanted risks, many investors take a total return approach to drawdown. This involves combining both the income generated through dividends and coupons along with taking some of the profits from capital appreciation to maximise retirement income.
For many, it makes sense from an investment standpoint. The reality is, it makes little difference whether the income you take is generated by dividends or capital gains. It also gives you greater control over the amount of cash flow generated because you are not dependent on how total returns are split between yield and capital appreciation.
Adopting a total return approach also means your portfolio retains a greater degree of diversification. With the natural yield approach, by focusing entirely on generating an income, there is a risk that the underlying portfolio won’t be as diversified as it could or should be. This could result in returns being lower or more volatile.
A total return approach also gives you more control over the size and timing of any withdrawals. By not being dependent on a natural yield strategy, you can take any additional income requirements from your investments by drawing on your capital appreciation to ensure you have enough money to fund your retirement spending needs.
In reality, how a total return strategy works out for you depends on the asset allocation in your portfolio and the concomitant capital returns and dividend yield delivered by it. When withdrawing from capital, savers also need to factor in inflation.
Getting the best retirement income for you
Both strategies have their advocates but which approach is right for you will depend on your own individual circumstances. In an ideal world, a natural yield strategy would be the optimum solution but, in the real one, most will need to dip into their capital at certain points in their retirement.
It’s a difficult call to make, which is why it makes sense to get independent financial advice to help you understand the options and ramifications – and to come to the right decision.
So, if you are looking at ways to maximise your retirement income, contact us today for some professional retirement advice.