Retirement used to be more straightforward for many people. If you worked for one employer and built-up benefits in a final salary pension scheme, you could often stop work with a guaranteed, inflation-linked income for life. This was later topped up by the State Pension and pension income arrived much like a salary, without you needing to decide how much to take each year.
This is not what retirement will look like for many future retirees. Most people will have worked for several employers and, apart from a relatively small number of individuals, will not have access to a final salary pension. Although automatic enrolment means many people receive employer pension contributions, the responsibility for building and managing retirement savings now sits firmly with the individual.
Depending on the saver’s circumstances, a retirement income plan may draw on several sources - defined contribution pensions, ISAs and other investments, rental income and, for many people, the State Pension. Where someone has built up a pot of savings in pensions and investments, one of the most common questions is: “How much can I take each year without running out of money in later life?”
The 4% Rule
One idea that has been discussed in financial planning for many years is the 4% rule. Developed by the US financial planner William Bengen in the mid-1990s, it suggested that an initial withdrawal of 4% of a portfolio, increased with inflation each year, had historically been very likely to last for at least 30 years. The original research assumed a balanced portfolio, broadly split 50/50 between equities and bonds, and tested using US market returns since 1926.
More recently, Morningstar Wealth revisited this analysis for UK investors using updated market returns. It also looked at different equity allocations, ranging from 0% to 100%, and different retirement time horizons, from 10 to 40 years. It also considered the likely value of the remaining fund at the end of each period, as well as the effect of varying withdrawals from year to year (often described as “dynamic” withdrawals).
Each model was tested 1,000 times. A withdrawal rate was treated as successful if the portfolio did not run out of money in at least 900 of those 1,000 tests, equivalent to a 90% success rate. As ever with investing, this does not create a guarantee; it simply gives a way of comparing different levels of confidence.
What the analysis suggests
If you are comfortable taking a flat, inflation-linked withdrawal, 4.1% was the “safest” withdrawal rate over 30 years. This is very close to the original analysis by William Bengen.
If you were comfortable adjusting the withdrawal over time, for example by not inflation-linking it or reducing withdrawals during difficult investment markets, the starting withdrawal could be as high as 5.7% per annum.
A more conservative investment approach, with a greater allocation to bonds rather than equities, gave the greatest chance of not running out of funds.
There was a trade-off. If you also wanted a better chance of leaving a residual fund at the end of the period (perhaps for beneficiaries/the next generation), a higher equity allocation became more important.
Good investment performance in the early years was key. Of the many scenarios tested, the highest failure rate came from low or negative investment returns in the first five years.
The role of tax and personalised planning
This analysis is highly relevant for anyone trying to turn retirement savings into a sustainable income. It deals with one of life’s few certainties, death, by testing different time periods. What it does not fully address is the other certainty: tax.
For many future retirees, income may come from several different pots, such as ISAs, pensions and rental property, each with different tax implications. Drawing from those pots in the wrong order, or without considering the tax position, can reduce the sustainability of a retirement plan just as much as choosing an unsuitable withdrawal rate. This is an area where personalised advice can make a real difference.
Every retirement is different. If you would like to explore what a sustainable retirement income might look like for you, we would be happy to help. Get in touch to discuss your plans and build a strategy designed around your goals.
Important information: This article is for information purposes only and does not constitute financial advice. Any advice should be based on your individual circumstances. The information and guidance provided in this article is subject to the UK regulatory regime and is therefore primarily targeted at consumers based in the UK. The value of investments and pensions, and any income from them, can fall as well as rise, and you may not get back the full amount invested. Levels and bases of, and reliefs from, taxation are subject to change and their value will depend upon personal circumstances. Taxation and pension legislation may change in the future.