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When it comes to retirement and drawdown, it can be a minefield and very confusing when it comes to trying to work out how much income you should take from your pension or investments, to try and avoid running out of money.
It’s common to hear about ‘safe’ withdrawal rates, which is the amount of income you plan on taking dividing by the starting pension. 4% is a very common rule of thumb whereas you often hear 3% is a more conservative figure whilst others would say that you should be ok with 5%.
Using a static withdrawal rate isn’t a panacea as there are a number of issues with blindly relying on a fixed withdrawal rate. One of the biggest risks with using a static withdrawal rate is that it doesn’t take into account something called the sequence of returns risk, which is the idea that the timing of investment returns makes a huge difference, particularly when you consider at which point you retire.
Simply put, if the day before you retire there is a stock market crash and your portfolio is down 35%, this will have a much bigger impact on the sustainability of your pension fund compared to someone on the other side of spectrum who retires and the stock market goes on a tear and the individual benefits from stock market growth which more than offsets the withdrawals, as has been the case since 2009 or so.
Another criticism of a static withdrawal rate is that if on the other side of the coin investment returns are strong and your portfolios increases in value, it doesn’t allow you to benefit from this and perhaps take an increased amount of income.
Is there a better way – Variable ‘Guardrail’ withdrawal rates
In 2004 a financial planner, Jonathon Guyton and computer scientist, William Killinger, carried out some research on withdrawal rates. Their thesis was that traditional methods such as the 4% rule or an even lower withdrawal rate was in fact far too conservative, meaning retirees were potentially taking less income at the expense of not enjoying their retirement as much as possible.
Their research centred around using a dynamic withdrawal rate, which is really a fancy word for saying a withdrawal strategy that adjusts in line with a portfolios performance, in both upwards and downward markets and adjusting the amount of income taken accordingly.
Their TLDR was that by using a dynamic withdrawal rate, this may allow you to actually spend more money in retirement and at the same time avoid running out of money.
Their research covered two periods; 1973-2004 and 1928-2004 which captured some of the most severe bear markets such as the Oil Crisis in the 1970’s and stagflation.
Guyton calculated that the maximum initial withdrawal rate for this period was 5.80% for a portfolio made up of 65% equities with a 90% probability of success which was defined as not running out of money during a 40 year retirement horizon.
They also found the initial starting withdrawal rate increased to a whopping 6.20% for a portfolio made up of 80% equities with a 95% probaiblity of success. So that’s all when and good, but what does this actually mean?
The big takeaway is that for retirees who are looking to squeeze as much income as sustainably as possible from their investments, the guardrail approach could be a good option. However, the usual caveats apply, although the 70’s was an awful period for stocks, its plausible future returns could be much worse which could make these withdrawal rates far too optimistic.
How does a guardrails withdrawal strategy work?
Essentially in an upward trending market, the guardrails approach allows you to take more income, and conversely in a downward trending market, it requires you to reduce the amount of income you take. The potted version is that once your portfolio either increases or reduces by more than 20%, you increase or reduce the amount of income taken by 10%.
In their research, In the final 15 years before the planned life expectancy, the requirement to reduce the capital after a corresponding drop in the portfolios value was removed. This is because they found that reducing the income after this point had little to no effect on the success of not running out of money.
An example of the Guardrails Withdrawal Strategy in an up market
- Kevin’s portfolio is £500k and he is taking a starting withdrawal rate of 4%, which equals £20,000 per year.
- Two and a half years later his portfolio has risen to £700,000 after a resurgent bull market.
How much income can he now take as his portfolio has increased by more than 20%?
- Step 1 – His portfolio has risen by 40% (£700k/£500k)
- Step 2 – Inflation adjust the starting income – £20,000 x 1.06% = £ 21,200
- Step 3 – Calculate the new withdrawal rate – £21,200/£700,000 = 3.03%
- Step 4 – Work out difference in the withdrawal rate – 3.03%/4% -1 = 24% lower
Step 5 – As the new withdrawal rate is lower by more than 20%, he can increase his income by 10%. That is £21,200 x 1.10 = £23,320
An example of the Guardrails Withdrawal Strategy in a down market
So let’s assume that Kevin retired a year ago and when he comes to his 1 year retirement anniversary, a stock market crash has occurred and his portfolio is down by 35%. Will the guard rails approach mean he has to take less income?
- Step 1 – His portfolio has fallen by 35% from £500,000 down to £325,000.
- Step 2 – Inflation adjust the starting income – £20,000 x 1.06% = £ 21,200
- Step 3 – Calculate the new withdrawal rate – £21,600/£325,000 = 6.65%
- Step 4 – Work out difference in the withdrawal rate – 6.65%/4% -1 = 66% higher
As the new withdrawal rate is higher by more than 20%, he must decrease the adjusted inflation income down by 10%. That is £21,200 x 0.90 = £19,080.
What are the advantages of the Guardrail Withdrawal Strategy?
Advantage 1 – You can withdraw more money
One of the biggest advantages of the Guardrails approach is that, according to Morningstar’s research, for an investor with a 50% equity and 50% bond allocation, of all the safe withdrawal rail systems, this strategy gave the highest starting amount of income out of all the systems they tested at 5.3% over a 30 year retirement horizon.
For investors willing to allocate more to ‘riskier’ assets, the starting safe withdrawal rate was even higher at 5.60% for investors willing to allocate 80% of their portfolio to stocks and 6.30% for all equity portfolios!
Using a guardrails approach can be a good idea for retirees who may have a smaller portfolio, late to retirement planning or those who are simply looking to maximise their income from their retirement accounts in a sustainable manner.
Advantage 2 – Reacts to a changing investment enviroment
Although the evidence for this system is steeped in historical data, it reacts to a changing world. It is impossible to legislate for poor investment returns than in the past, higher inflation, more stock market crashes and bear markets.
It is possible all the above could be much worse than in the past and this dynamic approach will reduce the income if the parameters are met.
In contrast to a static withdrawal rate such as the 4%, using this come what may it is possible that much worse than expected scenarios could leave you with a nasty surprise.
Using a guardrails approach ensures that there is less money left in the retirement account at the end of the expected retirement.
One issue we find as Independent Financial Advisers, is that retirees often spend much less than expected as they lived in fear of running out of money, which seldom materialises. This could mean a lower standard of living in retirement.
Using a guardrails approach will encourage you to increase your spending if market conditions allows and as the cutback rule is scrapped in the final 15 years of retirement, this approach can force you to spend your money which could mean more of the cruises you wanted to do.
What are the disadvantages of the Guardrail Withdrawal Strategy?
Disadvantage 1 – More complex than a simple static withdrawal rate such as the 4% rule
The biggest disadvantages of this method to my mind, is that is requires ongoing maintenance and is somewhat complex. It is not a set it and forget it withdrawal strategy such as the ‘4% rule’.
I must admit in the example I did earlier, in the first draft, whist checking my work it became apparent that I had fudged my numbers!
Disadvantage 2 – Adjusting the income or a variable income may not be possible for some
As the guardrails approach requires retirees to alter the income depending on market conditions, which could mean an increase but also a reduction in the amount of income actually taken. For retirees who have core or essential expenditure that needs to be met, the requirement to drop the level of income taken not be feasible or possible.
Disadvantage 3 – As encourages you to spend more, less money at the end for inheritance etc
As the guardrail approach stipulates that you can take more income from your portfolio after the investment performance is greater than 20%, it encourages you to spend more and so this translates to a lower median ending balance.
Along with the guardrail approach being abandoned all together in the final 15 years of the expected life expectancy, this all means a lower ending portfolio balance compared to other withdrawal approaches.
For retirees who are not interested in leaving a bequest, this isn’t an issue. However, if you wish to leave some of your pension behind to your loved ones, this can be important. It doesn’t also account for a UK audience and the inheritance tax position of UK Defined Contribution pension. Under current legislation, pensions are in a lot of cases, but not all the time, outside your estate for the purposes of inheritance tax and will not be included as part of your estate when calculating if any inheritance tax due.
Therefore, the guardrail approach may not be as useful for retirees who are both looking to take advantage of the inheritance tax position on UK Defined Contribution pensions as they are typically exempt from Inheritance Tax.
Frequently Asked Questions
How Does the Guardrails Withdrawal Strategy Work?
With the guardrails approach, this stipulates increasing or decreasing the initial chosen starting withdrawal rate to account for changes in the value of your investment portfolio.
Once your portfolio increases or decreases by more than 20%, you increase or reduce the amount of income taken by more than 10%.
The requirement to reduce your income after a corresponding 20% fall in value is removed once somebody is 15 yeares within the planned life expectancy. In other words if Kevin’s planned life expectancy is age 90 and at age 80 his portfolio falls by more than 20%, he would no longer have to adjust his income downwards.
Why is the guardrails approach better than the 4% rule?
It’s not that the 4% rule or other static wsithdrawal rate is better or worse than the guardrails apporach. Instead the guardrails approach has sveral unique benefits compared to the 4% rule such as the research concluded that you would be able to take a higher starting income compared to the 4% rule.
Another advantage of the guardrails apporach is that as it requires you to reduce your income once your portfolio falls by more than 20%, this helps to protect against the sequence of returns risk.
How is the guardrails withdrawal strategy different to the 4% rule?
The 4% withdrawal rate or other verison of it stipulates that you take 4% of the portfolio which is then increased by inflation each year. For example, if your portfolio was £100,000 at the time you retired, you would take £4,000 as a starting income.
In the next year, if inflation was 2% during this time your new income would be £4,080 per year (£4,000 x 1.02) even if your portfolio had fallen to £90,000.
With the guardrails approach you select an initial starting withdrawal rate such as 5%, but once your portfolio increases or reduces by more than 20%, you increase or reduce the withdrawal rate by 10%.
What is the maximum amount of income suggested using this strategy
Guyton and Klinger in their research found that for a portfolio made up of 65% equities, a starting withdrawal rate between 5.20%-5.60% was sustainable with a 99% confidence.
They found for a portfolio with a higher weighting of 80% to equities, a starting withdrawal rate of 6.20% was sustainable with a 95% probability of success, with success being not running out of money over a 40 year horizon during two periods which were 1973-2004 and 1928-2004.
The value of investments and any income from them can fall and rise, and you may not get back the original amount invested. Past performance is not a reliable indicator of future performance and should not be relied upon.
