It’s not a question people needed to worry about as much prior to 2015. Because back then when you retired it was compulsory to buy something called an ‘annuity’ with your pension savings – a type of financial product that is usually sold by insurance companies and pays a guaranteed income, often lasting a lifetime.
But nowadays, increasingly, people have more choice and freedom over how they draw an income from their pension.
You can still get an annuity if you want. And, of course, the amount of money you get from the state pension is still decided by the government of the day. What’s more, pensions that are of the ‘defined benefit’ variety – which covers many older private workplace and most public sector pensions – pay their retired members a regular income too.
For all other pensions, though – ‘defined contribution’ schemes, which comprises most current workplace pensions and all personal pensions, including self-invested personal pensions (SIPPs) – there is more choice. As well as the first 25% being tax-free, you can choose to take additional lump sums at a time of your choosing or specify a regular income that you would like to receive.
And you can do it from as early on as aged 55 (rising to 57 in 2028), rather than wait until you reach the state pension age more than 10 years later1.
All of which presents a challenge because what if you take too much too quickly and end up with nothing but your state pension? It’s a particularly prescient question at a time when everything is becoming more expensive due to higher inflation.
Old not-so reliable?
Historically, the 4% rule has been a mainstay for anyone wanting to live off their retirement savings. This includes members of the Financial Independence, Retire Early (Fire) movement.
What that means is withdrawing 4% of your money in the first year of retirement and then increasing the amount each subsequent year to account for the prevailing inflation rate, leaving the rest invested in a combination of bonds and shares so that it can continue earning a relatively steady return and grow.
The formula is sometimes expressed in a slightly different way in the UK – as in making sure you start with a pot that is 25 times your annual expenses. But essentially it’s the same thing and based on research first published almost 30 years ago by the American financial adviser William Bengen2.
The 4% rule has served its devotees well in the decades since, our research shows. But the world more recently appears to have changed. So much so, even Mr. Bengen is urging greater caution.
To explain why and what the implications might be for retired investors requires a deeper understanding of the factors that made the 4% rule dependable in the first place. And what our US economists found after trawling through the historical data, all the way back to 1960, is that its success rested not only on how well a retiree’s investments fared but also on how low inflation was, how much markets swung about from year to year and how different bonds and shares behaved in relation to each other – or, to use the correct statistical term, their correlation3.
The analysis undertaken is complex but what it shows is that these three factors, when looked at together, can also influence what constitutes a sustainable rate of withdrawal – or, more precisely, what would give a pension pot a high probability of lasting at least 30 years (bearing in mind that life expectancy at birth in the UK is 79 years for men and 82.9 years for women4).
What’s more, these additional factors may be even more relevant now, our economists concluded5.
Adjusting to new realities
So what’s actually changed for retirees and how can those who depend on their pension pots adapt?
According to our research, which is built on the Philadelphia Federal Reserve’s 10-year projections for higher inflation and moderate-to-low returns for both shares and bonds, a sustainable inflation-adjusted annual withdrawal rate may now be more like 2.8% to 3.3% rather than 4%.
We emphasise that our findings shown in the chart below are based on US not UK data, so they should not simply be extrapolated across ‘the pond’. Still, based on this evidence, it’s not unreasonable to suggest that greater caution when drawing down your pension may be warranted now. After all, inflation has risen here too and market conditions have similarly changed.
Sustainable portfolio withdrawal scenarios for 2022 retirees—three scenarios
Annual inflation-adjusted withdrawal rates (estimated for the 30 years ending 2052)
Source: Vanguard calculations based on data from the Survey of Professional Forecasters, Morningstar, Inc. (intermediate-term U.S. government bond returns), Kenneth French’s Data Library (U.S. total stock market return), and Robert Shiller’s website (CPI).
Notes: The sustainable withdrawal rate assumes a percentage withdrawal from the portfolio’s initial balance that can be increased by the inflation rate over the 30 years starting in 2022. At this rate, the portfolio would avoid depletion over that period in 85% of all simulations.
Risk management mindset
Forecasts help us to identify a storm in advance so we can swerve, stall or batten down the hatches, even when sunny skies might appear to prevail. Many of those who have retired or are close to retiring also have the benefit of having lived through a period of really strong markets. So the fact they may have to lower their withdrawal rates to ensure their pension savings last at least 30 years is at least offset by the fact their balance has swelled during the bull market of recent years.
Those who have some way to go before they retire also have the option to reassess their retirement income goals and/or to consider increasing their pension contributions to maintain them.
Just as important for investors is to view a systematic withdrawal rate more as a jumping-off point than a hard-and-fast rule that must always be adhered to, because it can always be revised as the return outlook changes.
You can also employ what we like to term a ‘dynamic spending’ approach. It’s something I’ve written about before in greater detail and something we plan to provide customers more help with in the future.
But, in short, it entails adjusting the percentage of income you withdraw each year from your pension based on how well your portfolio performed in the previous year, subject to an inflation-adjusted floor or ceiling. The ceiling helps to build a buffer when markets have done well while the floor helps to maintain a reasonable level of spending if there’s been a sharp decline in value of your portfolio.
Our research6 shows that your chances of not running out of money – state pension aside – are significantly improved with a dynamic spending approach compared with simply increasing your income each year in line with inflation.
The need to make sound financial decisions doesn’t just go away because you are retired. In some respects, it can actually go up because you have to think about making sure you don’t outlive your investment portfolio, as well as potentially leaving bequests and changes in the investment outlook.
The decisions investors make in the first decade right after retirement, especially, can have a major bearing – as can market conditions during that time.
It’s more reason to continue taking a strategic approach to your finances all through your investment lifetime.
1 Currently 66, rising to 67 between 2026 and 2028 and then to 68 between 2044 and 2046.
2 Bengen, William; ‘Determining withdrawal rates using historical data’, Journal of Financial Planning, October 1994.
3 Rather than drive returns, which is the role of shares, the role of bonds in a multi-asset portfolio is to act as stabilisers. The less correlated they are with shares, the better they can perform this task. See ‘How government bonds complement your shareholdings’.
4 Average life expectancy is complex and can hide a multitude of possibilities. Find out your own personalised life expectancy using the government’s interactive calculator.
5 Khang, Kevin Ph.D, David Pakula CFA, and Andrew Clarke CFA; ‘Sustainable Withdrawal Rates by Return Environment: A Time-Varying Bayesian Analysis’ will be published in The Journal of Retirement later this year.
6 Daga, Ankul CFA, David Pakula, CFA and Jacob Bupp, ‘Sustainable spending rates in turbulent markets’, Vanguard Research, January 2021.
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