The theme of this three-part series is how to maximise your finances in retirement. In parts 1 and 2, we explained how you could potentially:
- Keep more of your hard-earned retirement money for yourself and extend the life of your pension by moving it to a lower-cost pension platform.
- Improve your chances of investment success in retirement with age-appropriate investment products.
In this final article, we focus on how to spend your retirement money – how you can synchronise your retirement expenditure with your investments so that your pension lasts longer.
It used to be the case that retirees could live off the ‘natural yield’ of their investments – that is, rely on the income paid out on their shares and bonds1. But with the interest (or yield) paid out on bonds so low these days, that’s a big ask – what’s more, you can’t rely on companies to always grow let alone pay dividends to shareholders.
Such an approach can also be hazardous to your wealth if it nudges you into taking ever-greater risks in search of investments promising a higher income.
That’s why a total-return approach, where you dip into your capital too, may be a better way to go. As our experts see it, you can gain more control over your quality of life in retirement if you lean on both the income and capital growth that your investments generate.
Still, how much should you pay yourself each year?
It’s a personal question that, in broad terms, you can more easily determine the longer you have left to retirement. Why? Because with more time on your side, you can more easily harness the power of compounding and plan your investments so you end up with a pension pot big enough to meet whatever income target you want to set yourself. It’s the sort of thing Vanguard Personal Financial Planning can help with.
But when you’re already retired or close to retirement, there is less room for manoeuvre. You have to play with the cards you’re already holding. Here, the question is more: What can I afford to pay myself so that my retirement savings don’t run out too early?
Some quick maths
One obvious approach is to withdraw a nominal amount – such as, say, £40,000 – and then adjust this figure each year for inflation. This has the advantage of giving you some certainty over your income and what it might buy you. However, doing this blindly without considering the overall size of your pension could also leave you with no money rather quickly, particularly if you have a run of years where your investments perform poorly.
An alternative is to think in percentage terms, by withdrawing a specific proportion of your starting portfolio each year, incrementally adjusted for inflation. Typically, this would be in the 4% to 6% range.
In this way, if you retire with an investment portfolio of £400,000 and your withdrawal rate is 5%, your starting annual income would be £20,000 (strike it lucky with a portfolio of at least £800,000 and it would be £40,000, and so on).
Remember: these calculations are based purely on your private retirement savings and do not include the state pension most of us are entitled when we reach our late 60s2. This is currently worth £9,3393 a year and is also an important source of money when thinking about your future spending power as a retiree.
A third approach is something we call ‘dynamic spending’, which adjusts the percentage of income you draw each year from your pension based on how well your portfolio performs in the intervening period but is also subject to an inflation-adjusted floor and ceiling.
We think a dynamic spending approach can give you income stability while reducing your risk of running out of money.
Suppose inflation is 2%, your starting portfolio is £400,000, your withdrawal rate is 5% and that you have a performance ceiling of +5% and floor of -2.5%. If in the first full year of retirement the value of your £400,000 portfolio rose by 20%, then the ceiling would mean that your income in year two would rise by only 5% plus inflation to about £21,400. If, however, the value of your portfolio fell by 20%, the floor would mean that your income dropped by only 2.5% (again, in inflation-adjusted terms) to about £19,900.
In the same way, if you started with a pension pot of £800,000, you would either have an income in the second year of £42,800 or £39,800, depending on the market scenario.
In short, while our ceiling helps to build a buffer in rising markets, the floor helps to maintain a reasonable level of spending after a sharp decline in value of the portfolio.
Testing the theory
We believe that the benefits of this more flexible approach to retirement spending is that it can help you spend more sustainably, giving you greater peace of mind as well as a potentially more comfortable retirement, in most market circumstances.
To test this, we modelled the likely performance of a theoretical portfolio of £800,000 over 30 years using Vanguard’s in-house market-forecasting tool4. In this, we assumed the retiree was invested in a diversified global portfolio split 60:40 between shares and bonds.
We then looked at how long that portfolio would probably last under three different starting-income scenarios: £30,000, £40,000 and £50,000.
What we found, as the chart below shows, is that a retiree who followed our dynamic-spending method of withdrawal would have a 97.6% chance of not running out of money if they kicked off their retirement with an income of £40,000. In contrast, someone who simply increased their income annually in line with inflation would only have a 76% probability of success.
The chances of success were even more dispersed when the initial income was set at £50,000: 73% versus 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%5
Nobody can predict the future. But we can give ourselves a better shot at investment success through a better understanding of the forces that shape our futures.
When it comes to investing, that means keeping our costs down and having appropriately balanced and diversified investments. This is especially true when we are retired and most depend on our investments, because the downside of getting it wrong is all the greater.
It’s why it’s also important to think about the way we spend our retirement money.
1 In the case of shares, this income entails the variable dividend payments that some companies may pay to shareholders out of the profits that they may make. The income due on a bond is represented by its ‘yield’, which measures the effective interest paid on a bond as a percentage of its changing price. For more on the differences between shares and bonds, click on the link.
2 Currently 66 years, rising to 67 for those born after 5 April 1961 and 68 for those born after 5 April 1978.
3 This rises by 1% for every 9 weeks deferred and works out at just under 5.8% for every 52 weeks.
4 The Vanguard Capital Markets Model (VCMM), a proprietary forecasting tool providing investors with a range of possible future expected returns for a wide range of asset classes. The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modelled asset class.
5 For more details about the assumptions used in our modelling, see Sustainable spending rates in turbulent markets, Ankul Daga, CFA, David Pakula, CFA and Jacob Bupp, Vanguard Research Note, January 2021.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
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