Is the ‘safe rate of withdrawal’ just a dangerous idea?
Most people gave a warm welcome to ‘pension freedoms’, which ended the effective compulsion to buy an annuity. But pensioners face a significant new risk: running out of money if they spend their retirement funds too quickly. What they need to know is how much they can afford to spend each year.
To find the answer, assumptions must be made about two key unknowns: the future rate of return from the portfolio and your life expectancy.
A good starting point is the respected Barclays Equity Gilt Study, which details returns back to 1890. It tells us that the average ‘real’ return (after allowing for inflation) of a portfolio split equally between UK shares (equities) and government bonds (gilts) has been 3.1% per year, over the past 135 years.
Turning to life expectancy, official mortality records suggest that 65-year-old women should reach 90 on average, implying an investment term of 25 years after retirement.
Based on these assumptions, this woman could withdraw up to 6% from her portfolio in the first year and then increase withdrawals in line with inflation for the rest of her life, with the capital exhausted just after death.
That sounds pretty encouraging but sadly the real world is not so simple. Although real investment returns have averaged 3.1% a year over the past 135 years, over 20 year periods they have varied from −2.7% to +9.8%. All we can say with certainty about the future is that the latter figure will not be matched because gilt yields – a key driver of returns – are now close to historic lows.
Our 65-year-old woman is predicted to live to 90. She might be unlucky enough to die just one day after her 65th birthday, but she also has a one-in-four chance of reaching 95. In fact, the odds are probably higher than that because life expectancy has been rising by about a year every decade.
Changing the investment return assumption to −2.7% a year and life expectancy to 30 years reduces the maximum withdrawal rate to 2.2%, with the value of the fund falling by 60% after 15 years. Hardly a comfortable prospect.
And that’s not all: investment returns will be volatile from year to year. When you withdraw money from a portfolio you are vulnerable to ‘pound cost ravaging’. This is the unfortunate counterpart to ‘pound cost averaging’ – a known bonus for regular savers – as you must sell more units to get the same amount of cash when prices are low.
This is particularly relevant during the first ten years of retirement; poor returns then are hard to recover from. As a result of all these factors, we don’t believe there is a safe fixed rate of withdrawal.
Does this mean everyone should buy an annuity?
Definitely not. An annuity may be the only way to insure against the risk of living longer than average but right now could be the worst time in history to buy one.
Bond yields are near record lows, with life expectancy on the rise, both of which have a direct negative impact on annuity terms. Pension freedoms have also made annuities less attractive – an actuarial consequence, as poorer people with lower life expectancy are no longer forced to buy them.
It’s probably better at the moment to keep a pool of cash on one side to maintain flexibility, and then review the situation regularly.
How about just withdrawing income, leaving your capital intact?
A typical UK equity income fund currently yields about 4%. Dividends usually rise at least in line with inflation, so surely that’s a better solution than playing roulette with your capital, or buying an annuity while gilt yields are at rock bottom?
It probably is but there are no guarantees. Go back to the Thirties and dividends from British shares more than halved within six years. If you were totally reliant on that income, you’d be in trouble.
The optimal course of action will depend on your circumstances and preferences, but here are a few general guidelines:
1) Split your expenditure into two groups
The first covers core essentials and emergencies: include all items that are needed to have a moderately comfortable lifestyle. Take steps to ensure that you will have enough income and capital to cover these costs in all circumstances plus enough liquid cash to cover 12 months’ spending.
The second group is discretionary spending: on holidays, asset purchases, etc. Be prepared to be flexible with these so you can reduce spending during tough times and minimise the impact of pound cost ravaging.
Most people find that these costs are higher in the earlier years of retirement but then tail off until the cost of care becomes a factor.
2) Take a look at all of your assets, including your home
There are several ways in which you can extract part of the capital value of a property while still being able to live there. While there are some disadvantages to this approach, it can be helpful from an inheritance tax perspective to maintain value in a pension fund rather than in a property.
3) Set an investment policy with care
You will need to be thinking about the long term and that suggests a high weighting to assets that provide some protection against inflation, such as shares and property. However, this will result in significant fluctuations in the portfolio value. It is absolutely essential that you don’t panic when markets are going through a period of turbulence, so make sure that you understand what a bad year might look like.
Don’t forget though, that the main objectives is to enjoy retirement, so strike a balance between frugality and fun.
» If you have any questions about the above, please do not hesitate to contact us.
A version of this article appeared first in The Telegraph on 23 September .