Many pensioners now draw an income from an invested pension (drawdown) and could well be over-exposing their savings to the stock market. Whilst most people are familiar with the usual warning that share prices can go down as well as up, few understand just how volatile and unpredictable equity investments can be. In the last 15 years, two major stock market downturns occurred, each time wiping out around half the value of the FTSE100.

Even comparatively modest falls of 10% can be disastrous and are much more common. Imagine your pension is valued at £100,000 and you expect to draw £10,000 from the account for at least 10 years. An immediate 10% drop in the portfolio value results in a loss of a whole year’s income, from which it can be difficult to recover.

Falls can happen quickly. Between May 2008 and February 2009, the FTSE100 fell by a staggering 38%, which is devastating for someone relying on the portfolio for pension income. Individuals in this situation become forced sellers; they have no choice but to sell off stock whilst values are low because they need to produce a cash income to live on.

Are equity returns really that good?

So, equities are volatile. But, at least they will, over time, generate better returns than bonds or savings accounts, right? The answer is: not always. From 30 June 1999 to 30 June 2014, the FTSE100 increased in value by just 5.76% – that’s a pitiful 0.4% per year.

Don’t underestimate the importance of timing. Timing plays a huge part in the success (or failure) of equity investments. The above example demonstrates exceptionally poor returns, but what about other time periods? Someone who invested from 30 June 2003 to 30 June 2007, for example, could have benefited from a 66.36% gain in the value of the FTSE100. This should serve as a stark warning for pension investors who, typically, have very little choice over timing. Money tends to go into a drawdown account on giving up work and then cash is regularly withdrawn thereafter.

What about dividends?

Capital gains (as discussed above) are not the only way to make money from equities, of course, many companies will pay a dividend to shareholders. When dividends are included, the FTSE100 performance from 30 June 1999 to 30 June 2014 is boosted to an annual return of 3.4%. Better… but not really good enough for the level of risk taken on by the investor.

Over the same time period, investors could have received a ‘risk free’ return of 6% a year simply by investing in a 15-year Gilt.

Reduce volatility

Individuals who rely on their invested pension portfolio for a regular income cannot normally tolerate fluctuations in its value. The primary objective should be to reduce volatility, whilst aiming for a smooth, predictable return that at least covers fees and inflation. Any extra should be viewed as a bonus, as long as you are not taking on too much risk chasing it.
Whilst it’s tempting to invest in something that might produce high returns, it’s wise to step back and reconsider. Research shows that the joy of a gain is only felt half as strongly as the pain of an equivalent loss.

FTSE100 performances source: Yahoo Finance (capital gain only) and Blackrock ishares (capital gain plus dividends).

James Baxter is a managing partner at Tideway.