Income withdrawal: what goes in and what comes out

Maybe you’re thinking about income withdrawal as a means to fund your retirement, you may well have considered the fact that by choosing to keep your savings invested, you can potentially make your money work harder and take income more tax-efficiently.

But, unlike buying an annuity, taking money directly from your pension fund in retirement requires ongoing management of your investments.  Otherwise you run the risk that your money won’t last long enough to support you for the rest of your life. So how can you decide how much you can afford to withdraw?

Investment and withdrawal

The returns you make on your investments, and the amount and timing of withdrawals you make from your retirement savings, will influence how much you can sustainably afford to withdraw.

The returns you make on your investments, and the amount and timing of withdrawals you make from your retirement savings, will influence how much you can sustainably afford to withdraw.

As you are investing over a period of typically 20 to 40 years, you should consider investments that are likely to produce the best returns over that time span. Historically, investing in equities (shares) and commercial property, either directly or via funds, has resulted in the best returns. However, investments such as equities and property can also be volatile and experience large falls in value, so strategies are required to cope in these situations such as maintaining a rainy day fund to draw income from.

The June 2015 edition of Thinking Ahead explains the four main asset classes, to read further information on this, click here

If you plan to take income withdrawals over your lifetime, investing all of your savings in one type of asset class isn’t usually a good idea. Diversification is a good idea because it means you don’t have all of your eggs in one basket.  Although you can buy funds that invest in a single asset class, you can also buy single funds that invest in a broad spread of different assets – these are referred to by a number of names such as ‘mixed funds’, ‘managed funds’, ‘balanced funds’, ‘diversified growth funds’ and ‘multi-asset funds’. 

Taking income withdrawals from a fund that is falling in value can do lasting damage to your retirement savings. If you are caught in the middle of a stock market crash you should take avoiding action – our article Already taking your retirement benefits and there’s a stock market crash? explains the actions you might take to mitigate the impact on your savings.

Rather than wait until you are caught out by a market correction or crash, it’s best to prepare in advance. Although investing in equities and property has historically produced the best returns, you should also expect the value of such investments to be volatile – that is, their value is likely to fall as well as rise. 

Ideally, you should keep two years’ worth of income in cash – a rainy day fund that you can draw on in times where the value of your riskier investments has fallen.

Drawing income from this cash means that you don’t need to take income from your other investments whilst their value is depressed. By doing this, you have given your other investments some breathing space to hopefully recover their value.

If your riskier investments are doing well and you don’t have a cash buffer or have depleted your cash buffer during a previous market correction, you should aim to replenish your cash in readiness for any future market correction.

You should also think about taking your income withdrawals from your riskier investments when they are performing well.

It’s only natural

Another less risky option might be to withdraw only the income that your investments produce, rather than drawing a combination of income and capital.

This income is often called the ‘natural income’. In the case of shares and equity funds, the income produced is called ‘dividends’; in the case of property it is the rental income (after costs); in the case of fixed interest, the interest or ‘coupon’ and in the case of cash, the interest.

Although investing in cash presents less risk to your capital, especially if you hold less than the amount protected by the Financial Services Compensation Scheme (£75,000 per UK authorised banking group), the interest or income produced is currently near historic lows.

The best instant access cash deposit accounts are currently producing income of about 1.3%. But if you are holding cash within your pension you will have to pay pension management charges which are likely to reduce the income you can take to between 0.3% and 0.8% without touching your capital. For example, if you had £100,000 pension savings invested in cash, the natural income after charges would only be £300 to £800 a year.

At the moment, investing in equities (shares) is likely to produce a better return or ‘yield’ than cash. The dividend yield of the FTSE All Share Index, which covers most of the shares traded in London was 3.7% at 31st March 2016. Even after management charges of between 0.5% to 1.2%, a £100,000 pension fund invested in this broad spread of UK equities would produce income typically between £2,500 and £3,200 a year. It’s worth remembering that although this would be considered a natural income, the capital value of you’re investment can still rise and fall in value and you may not get back the amount that has been invested.

The yield available on shares depends on the price you pay. The higher the price you pay, the lower the yield and vice versa. That means the best time to buy shares (or equity funds) is when their price is lower – for example, just after a stock market crash.

It is possible that the income from the shares you invest in will fall. Recently, some oil and mining companies have been forced to reduce the dividend they pay to shareholders, in some cases to zero.

Historically, dividend income across the whole stock market has tended to increase over time. You can take action to reduce the risk of dividend income cuts by investing in a wide portfolio of shares, or choosing an equity investment fund that invests in a wide portfolio of shares. By diversifying in this way, if one of the companies you are invested in cuts their dividend, another company you are invested in may be increasing their dividend – so overall you may not experience a reduction in income.

Fund managers create funds specifically aimed at people who are taking income withdrawals from their pension savings in retirement. These funds usually aim to provide a higher level of natural income or yield.

Share based funds that aim to provide a higher yield are usually referred to as ‘equity income’ funds. Fixed interest funds are also available that aim to pay a higher yield and are usually called ‘high income bond’ funds.

Another investment approach is ‘multi strategy’ investing. Instead of investing in one particular type of asset or a defined mix of different assets, the investment manager constantly reviews economic conditions, from which they generate new ideas for investments. A wider investment team then evaluates these ideas before making  specific investments. This type of fund aims to produce returns in both rising and falling markets and deliver returns with lower volatility than investing in shares-based or equity funds. These funds are also available in versions that aim to produce higher income which are usually called ‘target income’ funds.

Although the capital value of your equity, fixed interest and commercial property investments may fall in value, that doesn’t necessarily mean that the income these investments will produce will also fall. In fact, you could experience periods where the capital value of your investments is falling but the income or yield they produce is rising and vice versa.

By taking only the income from your investments, you are reducing the risk of your investment falling in value.  You may then decide to either draw on this as needed – for example, to pay for unexpected care costs in later life – or to leave to the next generation as an inheritance.

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