Fiona Tait outlines three ways advisers can assist clients worried about their pension income during the Covid-19 crisis
Since the introduction of pension freedoms, the number of people choosing to access their pension via income drawdown has rocketed, leaving many reliant on income from a pension plan that is still invested in the market. In the long term this can be a considerable advantage, but things do not look so good when markets crash.
It is all very well saying that clients should have known this could happen, but they still need reassurance amid the grim reality of a FSTE market that fell by more than 25% in two months between January and March this year.
1. Clients should have known that the value of investments can fall as well as rise. For most individuals entering drawdown, their pension is still a medium- to long-term investment. This means that investing in equities is required to offset the effects of withdrawals, charges and inflation and avoid running out of money too soon. As a result, the client can expect to experience a severe market shock at least once every ten years or so. Carrying out a crash test will help to prepare them for this.
There is no getting away from the fact that the most effective way to preserve the value of the fund is to reduce the amount that is being taken out of it
2. The grim reality is that clients with equity-based portfolios will have experienced significant reductions in fund value in the last two months. It is important to emphasise that unless these funds are withdrawn or converted to cash, these are only paper losses and it should be possible to mitigate the worst of the impact by leaving as much as possible still invested and ‘sitting it out’ until markets improve.
3. You can help clients by suggesting they meet income needs from the cash account or ‘short-term pot’ within their pension plan. Explain that withdrawing money from equity and bond funds would only consolidate the paper loss and could result in the client missing out on any ‘bounce back’ in market performance.
1. Clients should have known that pensions are very tax-efficient investments and it may be more effective to meet current income needs using other assets and leaving the pension funds until last. This is especially true if the client is looking to pass on benefits to family members on death, and even more so when pension funds perform badly.
2. The grim reality is that the short-term performance of pension plans is likely to look very poor in comparison with cash and deposit accounts. Clients may well be tempted to move their money away from what looks like a bad situation into one that looks better. This is a natural behavioural response and a chance for advisers to add value by preventing them from making emotionally driven decisions.
3. You can help clients by suggesting they use their non-pension assets, particularly cash and deposit investments, to provide income and wait for pension funds to recover. While it is impossible to state when this will be, most commentators believe the coronavirus effect is likely to be temporary and underlying market conditions are sound.
1. Clients should have known that under income drawdown the fund has to last as long as they need income. This means that it is good practice to estimate a sustainable withdrawal rate (SWR), based on the size of their initial fund and the length of time it needs to last. While many people believe that an SWR of about 3.5% a year should be achievable, in most circumstances a more individual approach may be taken using cashflow modelling. This also has the advantage of providing a visual illustration of how much clients can afford to spend on an ongoing basis.
2. The grim reality is that reduced fund values mean that any revised cashflow analysis carried out at the present time will show a much lower SWR than in previous annual reviews. Assuming a capacity for loss test was carried out, this could mean that some clients have to give up some of their lifestyle expenses but should still be able to cover essential spending.
3. You can help clients by suggesting they temporarily reduce their current withdrawals. There is no getting away from the fact that the most effective way to preserve the value of the fund is to reduce the amount that is being taken out of it. Reassure those who absolutely need ongoing income, or lump sums to compensate for other losses; they will still have access to it but should be aware that future investment performance on the reduced pension fund value may not be sufficient to offset these withdrawals and their future cashflow will have to be remodelled.
These are testing times for anyone who is reliant on their pension to provide income. In theory, those who have been through a robust advice process should have been prepared for this eventuality, however clients’ views can change when they are faced with the grim reality.
This is a genuine opportunity for advisers to demonstrate their value to clients by keeping them informed, helping them to overcome their natural fears and preventing them from taking actions that could make the situation worse.
Fiona Tait is technical director of Intelligent Pensions