Since the shift from Defined Benefit (DB) to Defined Contribution (DC), the coronavirus pandemic will probably be the first time some clients will be faced with investment management and the associated risks – and making sure their pension savings are on the right track to meet their retirement needs.
The same applies as we continue to adapt to a new normal of low interest rates, less attractive annuities and a trend towards greater pension flexibility.
Clients taking income through unit encashment need to have robust income plans and understand the implications of short-term decisions and the likely long-term impact these have on their investment values.
Reducing income through volatile periods or following a loss in investment value can go a long way to improving the long-term sustainability of an income plan. To bring this to life, we’ve created some examples on the benefits of reducing income and using income holidays.
Example 1 - Reducing income
This example shows a client investing £300,000 in late 2007, taking an income of £1,000 per month (4% a year). The orange line shows the impact of market volatility if the client continues to take £1,000 every month over the 12-year period to December 2019. The purple line shows the impact of market volatility if the client reduces their income to £500 (following some significant losses) and they maintain this level until their investment has had time to recover some of the losses. The shaded area shows the periods when the client takes a reduced income.
It’s important to note the benefit of reducing income through these periods isn’t apparent in the short-term.
The difference between the two scenarios, after the first period of reduced income (December 2009), is almost the same as the amount saved by not taking any income from their plan.
Looking at the long-term impact is where we see the value. Through the shaded areas, the purple scenario shows less losses when the client takes a reduced income. This preserved the fund value which compounds to the clients benefit over time, meaning after 12-years the purple scenario could result in the client having over £26,000 more in their pension.
Example 2 - Taking an income holiday case study
In this example, the same client invests £300,000 in late 2007, taking an income of £1,000 per month (4% a year). The orange line shows the client taking the same level of income across the full 12-year period. The purple line shows the client taking an income holiday (following some significant losses). They maintain this level until their investment has had time to recover some of the losses. The shaded area represents the client isn’t taking any income.
Again, the difference between the two scenarios after the first income holiday period is almost exactly the amount of income not taken from the plan, so no immediate benefit is seen.
However, after the full period, the scenario where the customer takes an income holiday during two periods of market volatility, could result in the client having over £52,000 more in their plan as losses weren’t seen through some of the most volatile periods.
To summarise, in example one the client is taking half the amount of income they had originally set up. In example two, the client takes no income for several months.
Many clients will be reliant on one source of income and using measures such as income holidays for several months would simply not be possible.
While these examples may seem extreme, they work to show that taking a long-term view is crucial, actively monitoring market events and their impact of your portfolio is necessary and through severe market events, even the smallest actions to reduce income can have a significant impact on investment values and income sustainability over time.