If you’re about to or have already retired and have a Defined Contribution pension or savings as a source of retirement income, then you are likely to be asking yourself:
“How much income can I draw each year without running out of money before the inevitable?”
This is the essence of the pension drawdown question.
Before we get into all that. There is a simple way to ensure to avoid such an outcome – purchase an annuity. However, since the 2008/09 crisis, bond yields and hence annuity rates have been heading lower and lower.
If you have insufficient guaranteed ‘fall back’ such as a defined benefit pension (including the state pension), a safety-first approach that an annuity offers may still be the only prudent course of action.
Otherwise, we can take a probability-based approach where we take more risk and in return have a higher expected return. Let’s look at that in more detail:
Regarding the original question about how much we can draw each year, the key variables that will drive this are:
- How long you are retired for
- How your investments perform
Let’s look at the first variable. How long you are retired for is a function of how long you end up living. However, we are NOT just speaking of life expectancy here. If your portfolio lasted as long as the average life expectancy, you would have a 50% chance of running out of money!
If you are retired as a couple, it gets even trickier. The chance that at least one partner in a 65 year old couple lives to be a 100 in the UK is 24%.
Let’s look at the second point. How your investments perform. By definition, we are taking risk here in an attempt to get a better return than the annuity we discussed at the beginning. By taking on investment risk, we are increasing our expected return (but not necessarily realised return).
What the actual investment may look like, or your asset allocation, is the subject for another day but let us assume that we are holding a globally diversified, passive, cost effective portfolio that matches the retirees attitude to risk and does not exceed their capacity for loss (the kind of portfolios we recommend here at Clara Wealth Management).
We don’t know how our portfolio will actually perform, but we have decades of historical data to give us information on the average, likely, unlikely and even highly unlikely outcomes (to the upside or downside).
Effectively we can assign probabilities to how long we will live and probabilities to different investment outcomes to arrive at a joint probability that you are still alive and the portfolio has depleted itself. That is, you have outlived your portfolio.
What we are looking for here is the holy grail of retirement planning, the Sustainable Withdrawal Rate (SWR). That is, a withdrawal rate that does not lead us to outliving our portfolio.
The 4% rule
The first SWR ‘rule of thumb’ was created by Bill Bengen, a former financial adviser in the US. He argued that, using US data and tax rates, a retiree could draw 4% of their starting pension balance, adjust for inflation each year and have a very high probability of not running out of money.
However, one would not have fared as well using the 4% rule if:
– you lived through a less fortunate time period than he used for his study (e.g. The Great Depression)
– were not invested exclusively in the American stock market
– were paying a higher rate of tax (like we generally do in the UK)
Mr Bengen also assumed a 30-year retirement. A couple retiring around the age of 60 has a good chance of one of them still being alive in 40 years time! The 4% rule is a start of the conversation but is not the solution.
A more rigorous approach would be to model the actual asset allocation of the retirees’ portfolio using a longer range of historical returns (50 or even a 100 years of data), model the distribution of their life expectancy and then calculate the possible outcomes and probabilities. This is the methodology adopted by Clara Wealth Management. The output for a retiree drawing an income/pension from their portfolio may look something like the below chart:
In the above graph, the blue line is the median outcome (you have a 50% of doing better or worse). The green and red lines represent the best and worst outcomes (respectively) that her portfolio would have experienced using a 100+ years of market return data.
In the above graph, the retiree would have run out of money at around the age of 87 in the worst historical scenario. She would have died very wealthy in the best scenario! We can also say she had a 10% chance of outliving her portfolio or that she had a 90% chance the portfolio would last until she was 95.
This above strategy may or may not be sufficiently ‘safe’. It would depend on a host of variables such as her health and other sources of income or assets. Depending on these variables, she could potentially draw a higher or lower income.
The above illustration also assumes that our retiree draws the same pension every year regardless of how her portfolio is fairing. We don’t tend to behave in this manner in our working years. That is, we adjust our budgets as circumstances change. Likewise, we can potentially increase the probability of not outliving our pension by adopting some pension Withdrawal Rules that decrease our spending as the markets go against us (and increase if they’re on our side).
The worst situation in retirement is to have a poor performing portfolio in the early years of retirement. To make an extreme point, a market crash on the last day of your life is less consequential than one on your first day of retirement! This is known as Sequence Risk.
The table below illustrates the point:
In the table above;
Example A starts with positive returns but ends with a poor performance.
Example B starts with a poor performance but ends well.
Example C is a mix of positive and negative performances.
Mathematically, it doesn’t matter which option you pick, they all return exactly the same total return of 1.75%.
Now, let’s see what happens when we take an income of 5% of the original capital each year.
The amount left of the original investment after six years as a percentage of the original investment, becomes very interesting:
As can be seen the sequence of returns has an impact on how long our portfolio will last. The large portfolio drawdown in Example B is sometimes called ‘pound-cost ravaging’.
With the above in mind, we can develop some pension withdrawal rules to reduce the worst of the pound-cost ravaging experienced in Example B above.
Some of the rules that may be utilised include:
Inflation-adjustment rule: Increase withdrawal in line with inflation unless the previous year’s portfolio total return was negative. Withdrawals are frozen in the years following a negative portfolio return to minimise the danger of pound-cost ravaging.
The portfolio management rule: Take the gains from an asset class that’s performed best in the previous year to provide the income. Move excess portfolio gains (beyond what’s needed for the withdrawal) into a cash account to fund future withdrawals.
The capital preservation rule: If the current withdrawal rate rises above 20% of the initial rate, then current spending is reduced by 10%.
The prosperity rule: Spending in the current year is raised by 10% if the current withdrawal rate has fallen by more than 20% below theinitial withdrawal rate. Doing this means the client does not miss out on higher sustainable spending when markets are doing well.
When designing your retirement plan, we take the layer cake of variables such as your attitude to risk, life expectancy, other sources of income or assets or a desire to leave a legacy and then design a rigorous retirement policy centred around an evidence based investment strategy.
For more information on the methods and software that we utilise please see the following pamphlet:
Please contact me at Clara Wealth Management at email@example.com or on 0207 097 4968 if you want to find out more or have any comments.
Pensions are long-term investments, the value of your investment and the income from it may go down as well as up. Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation. Past performance is not a reliable indicator of future performance.