What withdrawal rate works best for retirement? | Examples

What withdrawal rate works best for retirement?

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    Pension drawdown offers great flexibility, allowing you to withdraw any amount from your pension savings as you wish, whether that’s to provide a steady income, lump sums or both. However, pension drawdown offers no guarantees, and the freedom it affords can come at a cost.

    If market conditions are poor, you live longer than expected or take too much income from your pension, and you could deplete your pension too quickly, leaving you financially vulnerable in your later years.

    It’s importnant to establish a ‘safe’ pension withdrawal rate to ensure your pension savings sustain you throughout retirement. Some experts use a 4% rule, but it’s more advisable to base it on factors such as retirement age, other sources of income, spending needs and expected return on investments.

    In this article and accompanying video, I’ll take a look at the limitations of the 4% rule and explore the factors that determine what a safe withdrawal rate might look like using examples.

     Please get in touch for personalised advice and support to reach your retirement goals.

    What is a pension withdrawal rate?

    A withdrawal rate is simply the amount of retirement income you take from your pension or investments, divided by the value of your pension or retirement portfolio.

    The 4% rule of thumb is considered by some experts to be the amount you can safely withdraw from your investment portfolio to avoid running out of money in retirement, whilst others in the financial community argue anything between 3-5% is fine.

    What is the safest withdrawal rate from my drawdown pension?

    One question we get asked a lot is, ‘How much income should I take from my drawdown pension?‘ This is hard to answer as people tend to retire at different ages, have different retirement spending habits, different attitudes to investment risk and different inheritance objectives.    

    4% is widely considered a rule of thumb, but American finance expert Dave Ramsey recently caused a bit of a storm by declaring 8% as a safe rate of withdrawal.

    American finance expert Dave Ramsey

    Let’s examine the impact of withdrawal rates and other factors on the sustainability of pension savings in a bit more detail before looking at some case studies.

    What is the 4% rule?

    The much-vaunted 4% rule originated in a US study by a chap called Bill Bengen. He found that from the period of 1930-1970, a US retiree could have withdrawn 4% of their starting retirement savings a year (increasing with inflation in subsequent years) without running out of money over a retirement period of up to thirty years. It assumed the individual was invested in a balanced portfolio made up of US stocks and bonds. 

    What are the problems with the 4% rule?

    1. Focused on US data and investments only

    The first issue with the 4% rule is that Bengen’s data was based on the returns of US stocks and bonds. Historically, US stocks have significantly outperformed global stocks, as you can see in the data from a Credit Suisse study in 2022, which looks at the returns of various asset classes as far back as the 1900s.

    The results show that those investing in a global or diversified manner would have been wise to withdraw at a lower rate than 4%.

    Credit Suisse study, returns of various asset classes from 1900- 2022

    This then begs the question, if the US has been the best-performing stock market over this period, why not invest all the available equity from your retirement portfolio into US stocks?

    Firstly, the lack of diversification is an issue. There is no guarantee that US stocks will continue to outperform their global peers. For much of the 80s, Japanese equities were the darling of investors. However, had you invested in an index of Japanese equities since 1989, you would still be underwater until 2023.

    The evidence is quite shocking and has to be seen to be believed:

    Japanese equities from 1983 2023

    2. There’s no guarantee how long your retirement will be

    Another problem with the 4% rule and other safe withdrawal rates (SWRs) is that it’s impossible to predict your life expectancy and, therefore, your retirement period. It’s reasonable to assume that somebody with a retirement age of 55 would have to save much more than somebody who has a retirement age of 65.

    However, somebody who lives until age 100 is likely to need much more than somebody who passes away at age 85, and that’s even before getting into long-term care fees.  

    In the following two examples, we are going to look at the impact of life expectancy on a £200,000 pension savings pot to determine what a safe withdrawal rate might be.

    We will assume the following:

    • The person retires at 65
    • Investment returns are 4% a year and net of all fees
    • Inflation is 3% per year, and the starting income will be adjusted annually to increase by this amount each year
    • In example 1, the pension will run out at the age of 90
    • In example 2, the pension will run out at the age of 100

    Example 1 – Live until age 90 – Retirement term of 25 Years

    fund value vs income graph- Live until age 100 - Retirement term of 55 Years

    Example 2 – Live until age 100 – Retirement term of 35 Years

    If you plan for a life expectancy of 100, which is a retirement term of 35 years, you could safely take a starting income of £6,768 which represents a withdrawal rate of 3.38%.

    Fund value vs income graph- Live until age 100 - Retirement term of 35 Years

    Regardless of what age you retire and your life expectancy, the point remains: the longer you are retired, the lower the withdrawal rate needs to be to ensure you don’t run out of money.

    3. It’s impossible to predict investment returns and asset allocation matters 

    Another issue with withdrawal rates is that it doesn’t take into account your asset allocation (i.e. how your pension savings are distributed) or factor in future stock and bond returns.

    Based on the fact that historically, equities have rewarded investors, I had always believed that having a higher percentage of equity in your retirement assets would make it more sustainable and allow for a higher rate of withdrawal.

    However, Morningstar’s excellent recent research into safe withdrawal rates (which is well worth a read) found that if your retirement extends beyond thirty years, a lower equity allocation would allow you to take a higher withdrawal rate.

    Morningstar's 30-year starting safe withdrawal rate

    I guess this is because the longer your retirement is, the greater your chance of living through a period of poor investing returns, such as the Great Depression and the bursting of the tech bubble at the turn of the millennium.        

    I tend to be an optimist, but who knows? It’s possible that investment returns could be much worse in the future, with the effects of an ageing population across much of the West, China and Japan, climate change and eye-watering debt levels across many sovereign states.

    4. Sequence of Returns risk

    Withdrawal rates don’t take into account something called the sequence risk. This is the idea that the timing and order of your returns matter.

    To put this into context, if the stock market crashed on the eve of your retirement just before you started to take an income from your pension, the impact would be much greater than on someone who was still working and accumulating and could wait until their funds recovered.

    The best example of this can be seen by looking at how US stocks were hammered during the Great Depression (although I admit, it’s patchy going back that far).

    nyu stern historical returns from 1929 to 1932

    Let’s consider an event on this scale today. As an investor, you would certainly suffer. If you were also taking an income from your pension, it would be a double whammy.

    5. It doesn’t account for the timing of other income

    Another problem with withdrawal rates is that they don’t take into account the timing of any other income that you may have.

    Many retirees seek to finish work before they are eligible for the state pension. In this case, they may choose to take an income from their private pension in the early years until the state pension kicks in. This helps to ensure the long-term sustainability of the pension fund.

    Equally, if you wish to retire before the state pension age and you have a Defined Benefit pension, you may want to delay taking it so as not to incur any early retirement penalties, which depending on the scheme, could be as high as 3-5% for each year it’s taken early.

    Get a personalised withdrawal strategy with Heritage Financial Planning

    Rather than use an arbitrary withdrawal rate, it may be wise to carry out a cash flow plan every year with an independent financial planner to ensure your retirement planning on track.

    Heritage Financial Planning can help you determine how much money you need to save into your pension pot based on your planned retirement age and future spending needs. Together, we can help mitigate the risk of you running out of money during retirement and plan for the future you deserve.

    Contact us today to speak to one of our friendly personal finance experts.

    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.

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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