How much income before you bleed your pension dry? (2024)

When it comes to illustrating the risks of shunning annuities and using the new pension freedoms to take income directly from your investments, nothing I've seen does a better job than this.

John Lawson of Aviva, a respected and experienced pension professional, looked at what would have happened to the savings pot of a pensioner who used the "drawdown" approach to fund a retirement that started in 1999. The pensioner took the simplest (and cheapest) approach to investing the money in the stock market, putting it all in an "index-tracking" fund that simply mimics the performance of the FTSE All Share index.

The imaginary saver withdrew an income from the fund at exactly the same rate as he would have received income from an annuity, which in 1999 would have been 6.7pc.

The rather depressing result of this approach is that he would have run out of money this year, at the age of 81, when he would, with typical life expectancy, hope to live for another nine years. An annuity, of course, would pay him the same income for as long as he lived – for another nine years, in the average case.

Now, you may say, 1999 is a bit of a special case, as the market (and this pensioner's index fund) would have fallen very sharply the following year as the dotcom bubble burst. But no one ever knows what is around the corner. A wise pensioner who wants to exercise the new freedom to avoid annuities and chooses drawdown instead will want an investment strategy that can cope with a sudden fall in the markets.

Before we look for such a strategy we should delve into why exactly a fall in the stock market was so catastrophic for our saver. After all, shares did eventually recover (the FTSE All Share regained its former highs earlier than the FTSE 100, which did so only recently).

The key is in the saver's decision – natural enough in the circ*mstances – to take a fixed amount from his pension fund each month, mimicking an annuity. But if he was withdrawing the same as an annuity would pay, some of each withdrawal would involve a sale of units in the fund, as the natural yield would not have been enough.

When the market fell in 2000, the yield would initially have been unaffected. But if each withdrawal needed, say, a top-up from the sale of units of £200, the number of units that needed to be sold to generate the £200 would have increased. In other words, the rate at which the capital was being depleted picked up. Each sale of units reduced the amount produced by the natural yield, meaning even more units had to be sold next time to maintain the income. A some point the situation became irrecoverable.

How to invest without exhausting pension money

There are several ways to avoid the disaster of a pension fund death spiral (also known as "pound cost ravaging" in a nod to this phenomenon's virtuous counterpart, "pound cost averaging", which means buying units more cheaply in a downturn if you invest a fixed amount each month).

First, the saver could have followed the advice of Warren Buffett and kept 10pc of his retirement fund in cash, making withdrawals from this money rather than the tracker fund when markets fell.

This money would eventually have run out, so then the saver's best course of action would be to reduce his income.

Another option is to choose a different fund in which to invest. The easiest way to avoid sharp falls in the value of a portfolio is to hold a diverse range of assets. Shares, bonds and property can all pay a decent income, but they tend not to rise and fall in unison.

Savers can buy a mixture of funds themselves or choose one that invests in a mix of assets – a "multi-asset income fund". Many fund firms are launching, or promoting, such funds to take advantage of the pension freedoms but one that catches the eye is Legal & General's Retirement Income Multi-Asset fund. As the name suggests, this fund is purpose built for drawdown. "The fund manager operates the asset mix knowing that it is the basis for drawdown for many customers," said Adrian Boulding of L&G. The fund is very new, so its track record is short. But it's great to see a fund whose manager knows who he is investing for – and adapts his approach to best meet their needs.

• richard.evans@telegraph.co.uk