Is your SIPP fund exposed to the dramatic effect of Pound-Cost Ravaging?
Ignore Pound-Cost Ravaging And You Could Lose Your SIPP Fund
The Very Real Risk Of Pound-Cost Ravaging
Following the introduction of pension freedoms in 2015, the right to draw whatever level of income you like from your SIPP from age 55 has been welcomed almost by everyone. However, the scrapping of the rules that limited the amount you could withdraw from your SIPP has significantly increased the risk your SIPP will run out of money, due to the dramatic effect of Pound-Cost Ravaging.
To ensure your income is sustainable throughout your retirement, you need to be aware of the consequence of drawing income when the market is growing slowly, when it’s flat, or when it’s falling in value. Even for relatively short periods of time.
Pound-Cost Averaging - Growing Your SIPP
Pound-Cost Averaging is a simple concept. You invest equal amounts into your SIPP on a regular basis, no matter whether the market is rising or falling. The theory is that you buy more of the market when it’s cheap and less when it’s expensive. It provides a savings discipline and avoids the temptation to try to time the market.
Pound-Cost Ravaging - Drawing Your Income
Pound-Cost Ravaging occurs when you draw income at a higher rate compared to the net growth of your SIPP fund. Depending on your level of income, you can be affected in a falling market, a flat market, and even a slowly growing market. Your SIPP value can erode quickly because assets may have to be sold to achieve your desired level of income. If you take too much income, your severely reduced fund may have little potential to bounce when the market recovers.
To illustrate this, had you invested £100,000 into the FTSE All-Share Index in 2000, and took a starting income of 6 per cent - £6,000 a year - rising by 2.5% each year, your pot would have halved in value by 2003 and would have run dry by 2015!
The Two Primary Constituents of Pound-Cost Ravaging
1. Volatility Drag
Volatility is one of the more commonly used words in the investment dictionary. Volatility Drag is a function of the cruel maths that govern the difference between average returns and compounded returns.
The idea is very simple. If a portfolio falls in value, it needs to work harder to go back to its initial value. Take a look at this example...
Two years ago, a SIPP worth £100k fell by 10 per cent. Last year, it grew by 10 per cent. The SIPP is worth £100k again, right? Wrong! At the end of the first year, the SIPP had fallen to £90k. To get back to the initial value of £100k, the SIPP needed to grow by 11.11 per cent, not 10 per cent. If it only grew by 10 per cent last year, it would now be worth £99k, not £100k. The £1,000 leakage is down to Volatility Drag.
Below is an illustration showing the effect of more dramatic falls. A 30 per cent fall in value needs growth of 43 per cent to restore its former value. And a fall of 50 per cent needs growth of 100 per cent to restore its former value.
2. Sequencing Risk
Sequencing Risk is a twin to Volatility Drag. It’s how the order of returns impacts portfolio longevity. The point is that poor returns in the first decade of retirement can cause untold damage to a SIPP’s value, even if these poor returns are followed by years of high returns. Despite good average returns over many years, poor initial returns can have a disproportionate effect on the outcome, because of the problem of Volatility Drag making it difficult for your fund to be restored to its former value. The result is that your SIPP fund could disappear well before you do!
Pound-Cost Averaging isn’t affected by Sequencing Risk, but it’s a huge problem within Pound-Cost Ravaging.
How To Cope With Pound-Cost Ravaging
The simplest and traditional way of securing a predicable, sustainable retirement income is to buy an annuity. But that means giving up your SIPP fund, and with interest rates at an all time low, the income you’ll secure these days is a fraction of what you might have earned in years gone by. It's not surprising therefore that many people choose Income Drawdown to fund their retirement income.
Income Drawdown is more flexible than buying an annuity. But be under no illusion: it takes an awful lot more work on your behalf to ensure you don’t run out of money.
As soon as the level of income you’re drawing from your SIPP is greater than the growth of your fund, Pound-Cost Ravaging becomes an issue. Added to the problem is the effect of inflation, and the charges imposed by your SIPP operator and where appropriate, the fees charged by your adviser and your discretionary fund manager, all of which reduce your net return.
Unless you’ve selected investments that produce a predictable level of income, such as interest bearing assets, you need to keep a very close watch on the performance of your SIPP fund, perhaps as frequently as monthly reviews, for if the market moves quickly against you, Pound-Cost Ravaging could have a dramatic effect.
When the problem arises, you could consider changing your investment strategy, perhaps to asset classes that aren’t exposed to the ups and downs of the market. And you may need to alter or even suspend your income withdrawals until the value of your SIPP fund begins to grow again.
Download The Pound-Cost Ravaging Report
For more information on this most important aspect of your SIPP, you can download a detailed report on Pound-Cost Ravaging, written by Abraham Okusanya, the founder and principal of Finalytiq. Click the image below or this Pound-Cost Ravaging link.
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AJ Bell Is Often The Best Value SIPP For Stockmarket Assets
Over time, charges can wipe out a huge part of your fund. We like AJ Bell because there are no set-up costs. If you hold passive funds, which is our preference, or shares, investment trusts, EFTs, gilts or bonds, you pay one small fixed fee no matter how large your fund. And when you come to draw your benefits either as occasional drawdown or UFPLS payments, there's a small charge for the whole year no matter how many times you access your money (many SIPP and SSAS providers charge more than this for each payment). However, you should always compare charges in detail, because AJ Bell could be more expensive than other providers, depending on the type of stockmarket assets you hold.
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