One of the most difficult questions you face if you’ve just retired is whether your pension will last for as long as you are likely to need it. It’s all the more demanding if your assets are invested in the stock market and you’ve been through a dip such as we saw in early 2020, when a mixed portfolio of bonds and shares could have lost a fifth or more of its value in just over a month (and an all-share one would have lost at least a third)1.
Against such an unnerving background, anyone relying on their portfolio to live on will have wondered how they could prevent their money running out prematurely.
One common strategy used by those in retirement is to set an annual level of income from the portfolio, and then increase it annually in line with inflation. This provides a high level of certainty about what income is likely to be from year to year, at least in the short term.
You might set an initial withdrawal of, say, £40,000 in the first year and then raise it each year by the inflation rate, say 2%, to give £40,800 in the second year and just over £41,600 in the third year. This makes budgeting easy, although there is also a substantial risk that you could run out of money fairly quickly if you suffer a run of bad markets and your portfolio loses value as your withdrawals continue to rise.
To avoid that, an alternative would be to only spend a set percentage of the portfolio every year. A typical rule of thumb is that around 4% or 5% of a portfolio is a sustainable annual amount to withdraw. Adopting this approach, the arithmetic means you would never run your pot down to nil, but you would have much less certainty about your income, with wide fluctuations from year to year.
For instance, it might have seemed in early 2020 that 5% of an £800,000 global portfolio of shares and bonds would provide an income of £40,000. By mid-March last year, though, it was more likely to look like £32,000 after markets tumbled in response to the Covid-19 pandemic.
A more flexible approach
We’ve done quite a bit of research testing different spending strategies for retirees2 and found a third way that treads a pragmatic path between these two extremes and captures some of the benefits of both. We call it “dynamic spending”.
According to this more-flexible method, you set your annual income as a cash sum, say £40,000, but then adjust it year by year depending on how well your portfolio performs, subject to a floor or ceiling.
Suppose that you set a ceiling of +5% and a floor of -2.5%. If in the first year the value of your portfolio rises by 20%, the ceiling would mean that your income would rise by only 5% in real (inflation adjusted) terms to £42,800. If, however, the value of your portfolio fell by 20%, the floor would mean that your income would drop by only 2.5% in real terms to £39,800. In this way, the ceiling helps to build a buffer in rising markets, while the floor helps to maintain a reasonable level of spending after a sharp decline in the portfolio.
Benefits of dynamic spending
The benefits of this flexible approach to income compared with simply raising your income in line with inflation builds up over time. To give you an idea, we compared both these methods against various benchmarks of success, such as how much you can sustainably spend, how long the portfolio could last and how much might be left for bequests. In all cases, the dynamic spending approach scored more highly.
We looked at how much you should be able to draw down from an £800,000 portfolio over 30 years with an 85% chance of not running out of money by the end of the period3. We found that dynamic spending would allow an average income of £46,400 – substantially more than the £37,600 allowed by the inflation-plus strategy.
We also compared the degree to which different starting income levels would last the course. Again, we based our tests on an £800,000 starting portfolio over 30 years. We found that a retiree using dynamic spending would have a more than 97.6% chance of not running out with a starting income of £40,000, whereas for someone who increased their income annually in line with inflation, the probability dropped to around 76%.
With a more lavish starting income of £50,000, the success rate fell markedly with the first approach. But it was still much better than 50:50 at 73%, whereas it slumped to less than one in three for the second approach (29%).
Will your portfolio last at least 30 years?
Source: Vanguard. Notes. Assuming: starting portfolio of £800,000 and starting withdrawal of £30,000 to £50,000. Time horizon: 30 years after March 2020. Asset allocation: domestic equity: 10%, international equity: 40%, domestic fixed income: 17.5%, international fixed income: 32.5%
And there was good news for the next generation too. We found that the beneficiaries of our £40,000 initial spender could reasonably expect to be left more than £550,000 with dynamic spending, even if they died after 30 years of retirement. By contrast, the inflation-plus retiree’s bequest would be less than £350,0004.
Nobody can predict the future and none of what we have said should be taken as a recommendation about what you can spend in retirement. Nonetheless, we think it shows that there is a sensible path that prudent retirees can follow to reduce the chances that they will outlive their savings.
Staying flexible about how you manage your spending should give you much needed peace of mind as you face uncertain and sometimes volatile markets.
If you are unsure on the right course of action, a financial adviser should be able to help you build a personalised plan for your retirement spending. Vanguard’s own advice service, Vanguard Personal Financial Planning, is for now targeted only at investors looking to build their retirement funds.
In the last article in our series, I’ll look at the different places from where you can draw retirement income and what the implications could be for your tax bill.
1 From their peak on 19 February to their low on 23 March, UK equity markets dropped by 35%. Source: Morningstar. Index is MSCI UK Price Index.
2 Sustainable spending rates in turbulent markets, Ankul Daga, CFA, David Pakula, CFA and Jacob Bupp, Vanguard Research Note, January 2021.
3 To model the performance of the portfolio over 30 years, we used the Vanguard Capital Markets Model, a proprietary forecasting tool that provides investors with a range of possible future expected returns for a wide range of asset classes. We assumed a diversified portfolio consisting of a 60%/40% equity/bond mix allocated between domestic and international investments. For more details about the assumptions used in our modelling, see Sustainable spending rates in turbulent markets.
4 These tests were run on the same basis as our earlier examples, i.e. an £800,000 starting portfolio over 30 years.
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