Managing Investment Volatility in Drawdown
One of the main concerns of using income drawdown in retirement is the fear that your pot will become prematurely exhausted and the income will run out. The sustainability of taking income from any investment portfolio relies on a combination of factors, such as: risk, return, volatility, the level of withdrawal and your life expectancy.
In a perfect world, we would all choose a predictable and stable return and withdrawal rate and be able to predict exactly how long income can be sustained for. However, this isn’t realistic when one factors in investment volatility, which can have a significant impact in two closely related, but different, ways:
- Pound cost ravaging – at its most simplistic, investment volatility is the rise and fall of a portfolio’s value over time. When an investment drops in value, it needs to work harder than the amount it fell just to catch back up to the same value before the drop. The withdrawal of income depletes the fund more quickly when markets are weak. We call this ‘pound cost ravaging.’
- Sequence risk – if a downturn happens early in your retirement and you are taking income, it has a greater impact than if the downturn had happened towards the end of your retirement. The sequence matters because a high proportion of negative returns in the earlier years of your retirement can have a lasting, detrimental impact. In contrast, the same level of negative returns has a far smaller impact if it occurs after several years of positive growth.
The Three Pots Strategy
One of our favoured methods for managing investment volatility is the Three Pots Strategy. This involves having three investment pots that vary in terms of their risk and return characteristics.
| Pot 1 – Cash | Pot 2 – Stable Growth | Pot 3 – Long Term Growth |
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Pot 1 – Cash: contains the cash needed to meet short-term living expenses for the first two years. It should also include an emergency fund for unanticipated expenses such as car repairs. With cash yields currently close to zero, pot 1 is dead money from a growth perspective, but the goal is to provide stability, security and liquidity to meet income needs not covered by other sources.
Pot 2 – Stable Growth: contains five or more years of the annual income needed in retirement. The pot should be invested in a Cautious or Balanced portfolio, preferably with reduced volatility, to provide stable (but lower) growth in the short to medium term.
Pot 3 – Long Term Growth: contains a diversified portfolio targeting medium to long term investment growth. Pots 1 and 2 provide sufficient funds to draw on, allowing pot 3 to grow and recover from any market downturn.