Understanding Pound Cost Ravaging and Its Impact on the Sustainability of Your Investment
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. You should always seek professional advice from an appropriately qualified adviser.
All contents are based on our understanding of current legislation, which is subject to change, any information provided here is only correct at the time of posting.
There is a risk to your capital and you may not get back the full amount invested. The value of investments, as well as the income from them, can fall as well as rise.
As you approach or enter retirement, managing your investments becomes increasingly important to ensure that your funds last as long as possible. A critical concept to understand during this phase is pound cost ravaging, sometimes referred to as sequence of returns risk. This is a situation that can seriously impact the sustainability and longevity of your investments, particularly if you are withdrawing money when markets are down.
In this post, we’ll explain what pound cost ravaging is, how it works, and its potential impact on your financial future. We’ll also look at a real-life example to illustrate the risks of withdrawing from your investments in a suppressed market versus delaying withdrawals until markets improve. Finally, we’ll stress the importance of maintaining an emergency fund to help mitigate these risks.
What is Pound Cost Ravaging?
Pound cost ravaging refers to the combined negative effect of withdrawing money from an investment while the value of the underlying assets is falling. It becomes particularly problematic when markets are volatile or in decline, as withdrawing during these times not only locks in losses but also leaves fewer assets to benefit from future market recoveries.
Unlike pound cost averaging, where regular contributions to an investment during fluctuating markets can work in your favour, pound cost ravaging happens when you are taking money out. When asset values are down and withdrawals are taken, more units of an investment must be sold to meet the required cash flow. This can severely deplete the portfolio, leaving less capital to generate future growth when the market recovers.
The result? Your investment may not last as long as expected, potentially putting your retirement income at risk.
Sequencing Risk: Timing of Withdrawals Matters
A crucial aspect of pound cost ravaging is sequencing risk, which refers to the order in which returns occur. If negative returns happen early in retirement—particularly when withdrawals are being made—the impact can be far more damaging than if the same poor returns happened later. This is because losses compounded by early withdrawals leave fewer assets in your portfolio to grow when markets recover.
Let’s consider two scenarios to illustrate this concept: one where withdrawals are taken in a declining market and one where withdrawals are delayed until the market recovers.
Real-Life Example: The Impact of Sequencing Risk
Imagine two retirees, Jane and Tom, both of whom retire with an investment portfolio worth £500,000.00. They both plan to withdraw £25,000.00 per year to cover their living expenses. However, the timing of their withdrawals coincides with very different market conditions.
Scenario 1: Jane Withdraws During a Suppressed Market
Jane retires in a year when the market experiences a sharp downturn. In the first three years of her retirement, the market returns are as follows:
• Year 1: -10%
• Year 2: -7%
• Year 3: -5%
In this scenario, Jane needs to withdraw £25,000 each year regardless of the market performance. Because the value of her portfolio is declining, she is forced to sell more and more units of her investments to meet her withdrawal needs. This accelerates the depletion of her portfolio.
By the end of Year 3, Jane’s portfolio has dropped significantly due to the combination of negative returns and ongoing withdrawals. Even though the market recovers in Years 4 and 5 with returns of +8% and +10%, Jane’s reduced portfolio size means the recovery has less of an impact, and her portfolio is now significantly depleted. She may face difficulties sustaining her withdrawals in future years, increasing the risk of running out of money.
Scenario 2: Tom Delays Withdrawals Until Markets Improve
Tom, on the other hand, retires at the same time as Jane but has an emergency fund and other assets that covers his living expenses for the two years of retirement. This allows him to delay withdrawals from his investment portfolio while the market is down.
During those three years of poor market performance, Tom only needs to make withdrawals in year 3, so his portfolio does not experience the same compounding effect of withdrawals and losses that Jane does. When the market recovers in Years 4 and 5, Tom’s portfolio benefits to a greater extent from the market rebound, and his portfolio is in a much healthier position than Jane’s.
When Tom starts making withdrawals in Year 4, his portfolio has had a chance to recover, and he’s better positioned to sustain his planned withdrawals over a longer period. He may consider taking a one-off withdrawal to replenish his emergency fund to protect himself from future downturns.
The Importance of an Emergency Fund
Tom’s situation highlights the critical importance of having an emergency fund. This cash buffer allows retirees to cover their living expenses without having to dip into their investments during periods of market decline. Having an emergency fund can give you the flexibility to wait for better market conditions before you make withdrawals, reducing the risk of pound cost ravaging.
A good rule of thumb is to have at least 6 to 12 months’ worth of living expenses in easily accessible savings. This can act as a safety net during volatile market periods, providing peace of mind that you won’t need to sell investments at a loss.
How to Protect Yourself from Pound Cost Ravaging
1. Build an Emergency Fund: As mentioned, having a readily accessible cash buffer is one of the most effective ways to reduce the impact of pound cost ravaging. It gives you the flexibility to delay withdrawals when markets are down.
2. Withdraw Carefully: If markets are in decline, consider reducing or pausing withdrawals if possible. Alternatively, withdraw from less volatile assets or income-generating investments that are not as affected by market fluctuations.
3. Diversify Your Portfolio: Having a well-diversified portfolio can help spread risk and reduce the likelihood of significant losses during market downturns. A combination of equities, bonds, and other asset classes can provide a more balanced approach to generating income in retirement.
4. Work with a Financial Adviser: A financial adviser can help you develop a withdrawal strategy tailored to your individual circumstances and goals. They can also guide you on managing sequencing risk and adjusting your plan as market conditions change.
Conclusion
Pound cost ravaging can have a significant impact on the longevity of your investment portfolio, particularly if withdrawals are made during market downturns. By understanding sequencing risk and employing strategies such as maintaining an emergency fund, diversifying your investments, and working with a financial adviser, you can help protect your retirement income and ensure that your investments last for the long term.
Careful planning and a well-thought-out approach to withdrawals can make all the difference in securing a comfortable and financially stable retirement.