You have spent your working life saving into a pension and now, at the point of retirement, you have a handsome sum set aside. You want to use it to generate as much income as possible to fund a fulfilling retirement, but at the same time you don’t want to run out of money later on. Neither do you want to spend your savings on an annuity. The question you face is this: how much should you withdraw from your pension each year to strike the best balance between those two requirements, to maximise your income while minimising the risk of outliving your savings?
One man more than any other has helped savers to answer this question. He is William Bengen, inventor of the ‘4% rule’.
Mr Bengen, an American financial planner, said savers in the first year of retirement should withdraw 4% of the starting value of their pension pot. That annual income should rise each successive year by the rate of inflation, irrespective of any fluctuations in the value of the pot.
In his research he modelled how this rule would have worked for savers who retired in any year from 1926 onwards (his original work was published in 1994), assuming that the pension pot was invested 50:50 in shares and government bonds. He found that in all cases during the period analysed, no matter how bad the market and economic conditions (and it included the Wall Street crash and the Great Depression), his rule would have allowed a saver’s money to last at least 30 years. In other words, even in a worst-case scenario, an initial withdrawal rate of 4% would see you through.
Since he published his initial paper Mr Bengen has been refining his ideas and has more recently said that, by choosing a wider range of assets in which to invest the pension, higher withdrawal rates can safely be taken.
There are dangers, of course: ultimately your money is invested in assets whose future value is unknown and could be severely affected by events in the markets and in the wider world. I asked Mr Bengen to identify the two biggest risks for retired savers who depend on their pension investments for income. This is what he said.
How to ensure your withdrawals are sustainable throughout retirement
Mr Bengen has devised a tool that followers of the 4% rule (who may in practice use a higher withdrawal rate) can use to ensure that their withdrawal plan remains on track as retirement progresses and as markets and other external circumstances evolve. The tool should ensure that you never risk running out of money before the 30th year of retirement – even if your initial withdrawal rate is indeed more than 4%.
This tool involves the calculation, at the start of retirement, of what each year’s withdrawals will be as a percentage of the theoretical value of the pot each year, assuming steady inflation and investment growth at historically average rates. You then compare, as retirement progresses, that hypothetical withdrawal rate with the actual one. The actual figure, calculated each year, is your actual withdrawal, in pounds, divided by the actual value of the pot at the beginning of that year. The two withdrawal rates, the hypothetical and the actual, are bound to differ because variations in inflation will affect the amount you withdraw each year, while the value of the pot will in practice fluctuate from year to year in line with the financial markets.
It is this difference between the hypothetical and the actual withdrawal rates that you need to pay attention to. Small, brief gaps are nothing to worry about but a wide and prolonged gap is a sign that withdrawals may be unsustainable.
Danger No 1: a bear market
Mr Bengen modelled two savers’ experiences of the early years of retirement. The first had an initial withdrawal rate – the amount withdrawn in the first year of retirement divided by the initial value of the pension pot – of 7.2%. Hang on, you say, I thought we were supposed to limit withdrawals to 4%? There are two points to make here: the first is that, as mentioned above, in later work he has increased that figure, to 4.7%, but the term ‘4% rule’ has become so entrenched that it is in common use regardless.
The second point is, as we mentioned earlier, that a 4% withdrawal rate is intended to be able to cope with the very worst-case scenario and individual savers can decide to take more income if they are prepared to accept some risk that their retirement pots may run out before 30 years. They may, for example, have other sources of income or expect an inheritance, or simply decide to take a little extra risk in return for a better standard of living. And, of course, they can use Mr Bengen’s tool, described in the section above, to keep income sustainability under review and be prepared to act if it appears to be threatened.
Mr Bengen modelled what would happen to a saver who started with a 7.2% withdrawal rate, increased his or her withdrawals each year in line with inflation and encountered, in Mr Bengen’s words, ‘a significant stock bear market in the second and third years’ of retirement that hit the value of the pension pot (invested 50:50 in stocks and bonds, remember). He then assumed that markets recovered, as they tend to do.
When he calculated that all-important gap between the actual withdrawal rates in the following years and the hypothetical ones calculated at the start of retirement, he found that after a sharp widening in the gap in the fifth year of retirement it narrowed appreciably in the following years. By year 10 it had almost disappeared. In other words, the retirement plan was back on track, even without any changes to the planned withdrawals.
Mr Bengen told me: ‘Although bear markets can have painful effects on portfolios in the short term, they are usually followed by recoveries, which enable the portfolio to regain its former value and then some. The lesson here is that in the event of a “normal” bear market in stocks, taking no action [i.e. maintaining withdrawals in line with the plan] might be the best strategy.’ He did warn that this reassuring conclusion might not apply to particularly severe bear markets. However, use of his tool for monitoring sustainability would warn the saver of the need to act.
Danger No 2: a severe bout of inflation
Mr Bengen also modelled a second scenario, which involved not just a bear market but a prolonged bout of inflation – specifically 4.6% in the first year of retirement and rising to 10.2% in the seventh year before a slow decline. In this case the saver started with a lower annual withdrawal rate of 5.5%. Use of the sustainability tool showed that the gap between the hypothetical and actual withdrawal rates ballooned in year five and was even higher in year 10, despite slight falls in years six and seven. In other words, withdrawals were unsustainable and had to be cut. In fact, what Mr Bengen called a ‘draconian’ reduction of 28% in the sixth year was needed to restore stability to the plan and prevent that big gap in the following years from developing.
The conclusion is clear: while a bear market in the early years of a retirement plan can be accommodated, sustained inflation is a far graver danger. Mr Bengen said: ‘In summary, a retirement withdrawal plan requires active management. Adjustments may have to be made during retirement, although not all deviations from the plan require immediate action. Bear markets come and go, and many can be safely ignored. However, high, sustained inflation may be the justification for panic!’ That panic, of course, takes the form of an assessment of sustainability and if necessary a cut in withdrawals.
If you would like to read more about Mr Bengen’s analysis of sustainable withdrawals, his new book on the subject, A Richer Retirement: Supercharging the 4% Rule to Spend More and Enjoy More, is available now.
All those aged over 50 qualify for a free session with the government-backed Pension Wise to discuss retirement options. This is classified as information and guidance rather than tailored financial advice, but could be a useful starting point. You can access the guidance online at www.moneyhelper.co.uk or over the telephone on 0800 138 3944.
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