The new pension rules coming in this April will entirely change the way we take our pension funds at retirement. Up until now, most people have used their pension to buy an annuity, giving them a set income for the rest of their life.
For many years there has also been an option to draw an income out of your fund instead (income drawdown). But for most retirees the amount that you can take has been capped at a level similar to what would be available from an annuity.
Only those with a certain level of guaranteed income – for example, from other pensions – have been able to withdraw as much as they like. However, under the new rules, everybody will be able to take out whatever they want – even the whole amount the day after you turn 55 if you want to. The first 25% will be tax-free and the rest will be taxed at your income-tax rate.
This change has been controversial. Supporters see it as freeing savers to fund their retirement in whatever way best suits them. Critics say that it will lead to people depleting their savings too quickly, ending up in poverty in later life.
While we’d agree that giving people the freedom and responsibility for making their own financial decisions is best, we don’t think the risks should be underestimated. Judging how much you can safely take out of your pension is not a simple decision.
Anybody planning to take advantage of the new rules needs to think carefully from the start about how much of their savings they can spend.
Three factors to consider
The right drawdown rate depends on three factors, none of which can be known for sure. These are:
1. How long you are going to live after retirement
Statistics tell us how much life expectancy the average person of a given age has, but each of us could live for significantly longer or shorter than that.
2. What your investment returns will be
History gives us an idea of average long-term investment returns, but it also shows that these vary significantly over time.
3. Whether your cost of living is likely to rise significantly
Again, history gives us an idea of typical inflation rates, but these have been volatile.
In addition, our personal cost of living increases will differ. Some retirees may find that their medical and care costs rise in later life, while others will remain in good health.
What this means is that any estimate of how much you can safely spend is subject to a lot of uncertainty.
Buying an annuity does away with much of this: it guarantees you an income for the rest of our life and it shifts the investment risk onto the insurer. As far as cost of living goes, you can get annuities where the income rises in line with inflation each year.
However, this won’t address the risk that your personal expenses rise significantly. That can be insured to an extent through products such as long-term care insurance, but these tend to be relatively expensive.
How much should you take out?
Clearly, buying an annuity takes a lot of the uncertainty and risk out of retirement planning. That said, annuity rates are low at present, reflecting the low interest rates available on the bonds that insurers invest in to fund them.
So it’s understandable that many investors consider them poor value, and will at least consider using drawdown when the new rules come into effect. Given that, what can we say about what a safe withdrawal rate might be?
By far the best-known research into this is a 1994 study* by American financial planner William Bengen.
Based on investment returns data from 1926 to 1992, he calculated the maximum that an investor with a 50/50 portfolio of US large-cap stocks and government bonds could have taken out each year without running out of money before they died (assumed to be 30 years after retirement).
He found that an investor who began by drawing 4% of the initial value of their fund each year and increased that payment inline with inflation each year would always have been safe.
The 4% rule quickly became an accepted approach among retirement planners in the US, where annuities are relatively uncommon. While some have criticised it for being simplistic and showed that more sophisticated tools can give higher withdrawal rates, that simplicity is attractive to people who don’t want to engage in complicated modelling.
A time to be conservative
But is the 4% rule really that safe? While US investment returns were volatile over the past century, they were relatively good by international standards. Indeed, a 2010 study** by Wade Pfau looked at the performance of the 4% rule across 17 countries and concluded that it would only have been safe in four of them, even using generous assumptions.
Safe rates varied widely, with especially poor results in countries that saw major wars fought on their territories. However, even in those that enjoyed a more favourable century, rates of 2.5%-3.5% were more typical.
While it’s impossible to predict future investment returns, they seem likely to be lower than in the past. So the lower end of these withdrawal rates is a more conservative assumption today.
That’s also consistent with current annuity rates: an inflation-linked annuity for a 60-year-old pays around £2,500 for every £100,000 invested. So while you can probably fund a moderately higher income through drawdown, anybody banking on taking out much more will run a significant risk of exhausting their savings too soon.
* Determining withdrawal rates using historical data, William Bengen, Journal of Financial Planning, October 1994
** An international perspective on safe withdrawal rates from retirement savings: the demise of the 4 percent rule?, Wade Pfau, National Graduate Institute for Policy Studies, September 2010