Retiring? How to Draw a Sustainable Pension Income…

Inflation Can Be a Pension Killer

The impact of inflation is well known. What £100 can buy you today will be significantly more than what £100 can buy you in 10 years. Underestimate the effects of inflation and you may exhaust your drawdown pension far too soon.

Whilst past rates of inflation and current government policy can provide a guide, we don’t know what the future rate of inflation will be.

Just a small increase in the rate of inflation can have a devastating effect on retirement spending power, as demonstrated below.

For example, £100 today would be the equivalent of £82 in 20 years if inflation is at 1%, but a mere £36 if inflation were at 5%. Under such a scenario, we’d have to draw much more heavily on our drawdown pension just to maintain our standard of living.

Whilst headline rates of inflation are a common measure, inflation is a rather personal thing. What each of us puts in our shopping baskets each week is likely to be very different and it changes as we move through retirement.

The below chart shows how weekly expenditure on “essential” items changes over time and also by “type” of retired household.

Don’t Underestimate the Impact of Inflation

Don’t underestimate the impact of inflation on the spending power of your drawdown pot. Also, be aware that it can vary significantly depending on the type of retirement that you want to have.

Therefore, it’s essential to factor for a meaningful rate of inflation when determining what you can afford to draw from your pension without the risk of depleting it too soon.

While this is a good place to start, your own personal inflation rate may need finessing.

We would recommend an ongoing appraisal of spending habits and a regular review of your inflation assumptions to ensure this remains meaningful to you.

Investment Returns Can Have a Huge Impact

One of the benefits of a drawdown arrangement is the opportunity for investment growth as the pot remains invested. This can of course help to offset withdrawals taken and prolong how long your pension will last.

However, the reverse is also true. Investments do and will go down as well as up. Drawing sums out of a pension pot that is experiencing negative investment returns will quickly compound with devastating effect.

This phenomenon is known as sequencing risk.

To look at this let us consider a hypothetical pension of £100,000, from which an individual draws £7,000 as income each year. If from outset investment returns are strong but get progressively weaker, after 10 years the fund will be worth £120,537.

If we reverse the order of returns, so investment returns are weak to start with, but maintain the £7,000 annual withdrawal, then after 10 years the fund will be worth just £71,951.

Whilst this is an oversimplified example, we can see these produce very different outcomes. It is the sequence of investment returns that greatly impacts whether a drawdown pension will be able to sustain withdrawals for life.

We cannot predict which way investments will move. Therefore your retirement plan needs to have the ability to cope with such adverse conditions. You need to ensure that you can afford to take this investment risk and that you have other resources, such as cash savings or lower risk investments, that you can draw on if markets move against you.

What is a Sustainable Rate of Withdrawal from a Drawdown Pension?

To combat some of the risks, and especially the investment risks, there have been attempts to work out exactly what a safe withdrawal rate from an investment is. Others have come up with a set of rules that provides a high level of probability that you will not outlive your retirement savings.

The Bengan Approach

This started in the US in the 1990s with research undertaken by a financial planner called William Bengen. His research pointed to a “safe withdrawal rate” of 4% of the portfolio’s initial value, with income taken increased by inflation each year, and would last for 30 years.

However, this research had many limitations and impractical applications for a UK pension drawdown strategy. To name but a few:

• It was based on US investment data alone
• The testing was based on one of the worst sequencing of investment periods of all time
• It was based on a static bond and equity investment asset allocation
• It took no account of the cost of investment or other charges.

The Guyton and Klinger Approach

Later research by Messrs Guyton and Klinger (one a US-based financial planner, the other a computer scientist) adapted the 4% safe withdrawal. They developed decision rules, such as:

• The withdrawal rule
  Increase withdrawal in line with inflation in the previous years, unless the previous year’s portfolio total return was negative.
• The portfolio management rule
  Extract the gains from an asset class that has performed best in the previous year to provide the income, and move excess portfolio gains (beyond what is needed for the withdrawal) into a cash account to fund future withdrawals.
• The capital preservation rule
  If the withdrawal rate rises above 20% of the initial rate, then spending should be reduced by 10%.
• The prosperity rule
  Spending in the current year is raised by 10% if the current withdrawal rate has fallen by more than 20% below the initial withdrawal rate.

These rules aimed to increase the initial withdrawal rate beyond 4% and also set guardrails to ensure spending was not so high as to drastically impede the longevity of the investment nor too low as to severely impact on lifestyle spending.

The Bucket Approach

Another school of thought addressed the investment structure and introduced the concept of the bucket approach.

Under such a scenario, short-term spending is held in cash; mid-term spending allocation invested into bonds and fixed interest; and assets allocated for the longer term are invested into equities. Periodically, the short-term bucket is topped up from the mid-term bucket and that in turn is topped up by the long-term bucket.

Equity Glidepath Approach

An alternative to this is the equity glidepath route, where “buckets” are not replenished. Instead, there is a gradual move to a more heavily weighted equity allocation as cash and fixed income assets are spent first allowing equites to hopefully realise their long-term growth potential.

What Pension Withdrawal Rate is Right for Me?

Whilst there has been much research and hypothesis into what you can do to ensure you do not run out of money in your retirement, there are no hard and fast rules.

Blind implementation of any of the above strategies is no panacea.

Your retirement plans, resources, situation and objectives must be reviewed at least annually.

You must be realistic about what assets you have at your disposal and what you can afford to spend. You must understand and appreciate the risks and be prepared to alter income expectations and your lifestyle should things not go to plan.

Drawdown can offer significant freedom and flexibility, but with that comes responsibility and risk — the level of drawdown that’s right for you will involve a fine balance between these elements.

Need Help? Who Are Drewberry…

As expert financial planners we help clients manage their retirement funds. We provide ongoing advice to ensure their plans are constantly reviewed to provide the peace of mind that’s needed to enjoy retirement.

We use state of the art software that can bring your current financial reality to life and demonstrate what plans could be put into place to improve your retirement.

How Drewberry Helps Our Drawdown Clients

Typically for clients entering drawdown and at each subsequent regular review we ensure we fully discuss and explore the following key areas to ensure your retirement remains on track. This means:

• Fully reviewing your retirement needs and investment strategy to ensure it remains suitable for you.
• Assessing core and lifestyle spending and demonstrate where this can be increased or where there may be a need to temporarily reduce aspirational spending.
• Adjusting your retirement planning to take account of any unforeseen changes in your situation or circumstances, setting new goals and means to meet them.
• Looking at the annuity purchase decision. Is now the right time to increase your secure income base either by full or partial annuitisation of your drawdown pot?
• Examining how other assets and savings can be used to provide tax efficiency or to allow investments to regain ground in adverse investment conditions.
• Considering ways of releasing “income” from property via downsizing or equity release. We discuss whether this is appropriate now or whether there is a potential need for this in the future.
• Considering existing debts. Is servicing a low interest debt and preserving a larger liquid asset base to meet income needs more beneficial to debt repayment. Equally we consider the Inheritance Tax consequences of this.

We apply a holistic planning process to your retirement drawing on the wealth of expertise of our team and resources available to us, to provide you with a sustainable and enjoyable retirement.

Meet Our Clients

Needed to transfer my pension from one company to another and thanks to Sam it went through very smoothly, also like to mention Casey who kept me informed throughout the transaction they were both very helpful, would highly recommend.

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12/08/2020

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