Can you safely withdraw 4 per cent a year from your pension?

April 13, 2017

Anna Sofat, a charted financial planner and managing director of Addidi Wealth Management, explains how to safely withdraw income directly from investments at retirement.

I need money to live off, but how much can I take out each year without eroding my pot too quickly? It’s the perennial dilemma of the income drawdown investor. 

Investment experts often mention the rule of four – the magic number when it comes to drawdown income. Draw 4 per cent, and the chance of running out completely within 30 years should be small, say the experts.

The 4 per cent rule is part of the answer, but not all of it. Our analysis of markets going back to 1900 shows that there is a 25 per cent likelihood a withdrawal rate of 4 per cent will completely deplete a pot in 30 years.

Purchasing power outcomes of a 4 per cent strategy:

Time from start Chance of depleting pot completely
10 years 0 per cent
20 years 9 per cent
30 years 25 per cent
40 years 38 per cent

Source: Albion Strategic Consulting

These figures assume a 60/40 equity/bonds and gilts portfolio, which is the minimum risk you need to make the strategy work. Invest more cautiously than this and you are likely to run your pot down even quicker – you need the bigger returns from equities to replenish your pot.

- Revealed: the amount of income pension savers can safely withdraw  

One in four chance of running out of cash

A 25 per cent chance of running out of cash is not too bad, but you can do better. By reducing your withdrawals in the bad years, you can reduce your risk of a shortfall even further by using a flexible model we call a dynamic 4 per cent approach.

By trimming your withdrawal to 3 per cent in years when markets fall 20 per cent and 2 per cent if they fall by 40 per cent, your chances of depleting your pot in 30 years are just 3 per cent. Over 20 years the chance of running out of cash is zero.

Purchasing power outcomes of a dynamic 4 per cent withdrawal strategy:

Time from start Chance of depleting pot completely
10 years 0 per cent
20 years 0 per cent
30 years 3 per cent
40 years 9 per cent

Source: Albion Strategic Consulting

How to withdraw a safe amount of income 

The dynamic 4 per cent rule tackles the phenomenon known as ‘pound/cost ravaging’, also known as ‘sequencing risk’ - one of the biggest risks to drawdown investors. It’s the impact of not just how big market falls are, or how often, but also when they happen.

If investment returns were constant, then managing your income drawdown portfolio would be easy. But returns do not come in straight lines.

- Why the 4 per cent income rule is flawed

If you are lucky enough to start your income drawdown strategy when markets are rising then these early gains give you a great chance of achieving and even beating your investment objectives. Because you can withdraw your income without even touching your initial investment, your likely future investment growth will be that much greater. Suffer a bad few years at the beginning of your retirement and deplete your fund further by withdrawing income, and markets will need to perform heroically to return your diminished pot back to where it started. 

Protect your income when markets fall 

By cutting withdrawals in the bad years, it means you have a bigger stake in the market to benefit when the rebound comes. You might think that adopting a smaller withdrawal rate, say 3 per cent, would be better. But our analysis shows that a dynamic 4 per cent, falling to 3 or 2 per cent in the bad years, actually works better, precisely because it tackles pound/cost ravaging.

To protect your income in the difficult years you should hold at least one year, and ideally three years’ income in cash. That way, in the bad years, when you flex your income down to 3 or 2 per cent, you can replace the lost income from the cash buffer. Then replenish it in good years. 

- The danger of pound-cost ravaging

 So, someone with a £500,000 pot would take 4 per cent - £20,000 – in good years, but if the 2 per cent withdrawal is triggered, would take £10,000 from the drawdown pot and £10,000 from the cash buffer. In most scenarios, you won’t need to dip into the pot for more than a few years, though the bigger the cash buffer you have, the more secure the strategy. 

A dynamic 4 per cent drawdown strategy is a smart way to manage your pot for income and is a key part of an integrated financial plan. As you get older you will be able to adapt your strategy and either start eating into your capital or buying an annuity, as age-related rates get more generous. Everyone’s circumstances are different, but the dynamic 4 per cent strategy should be the engine of the first half of your drawdown plan at the very least.

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