Let’s face it, retiring clients want to have their cake and eat it. They want the security of an annuity and the flexibility of drawdown pot. Accordingly, one of the most important financial planning challenges of the 21st century is to help clients make sure their pension pot lasts a finite but unknown period in retirement. Simultaneously, we want to prevent inflation, the thief that keeps on taking, from depleting the buying power of their income over what may be a 25, or possibly 30-year retirement.
Bengen’s ‘Safe Withdrawal Rate’
Nearly 20 years ago, in an attempt to help address this challenge, the popular ‘4% rule’, otherwise known as ‘safe withdrawal rate’ (SWR), was developed by US-based financial planner (now retired) Bill Bengen. Bengen simulated withdrawals from simple stock and bond portfolios over several 30-year periods, starting from 1926. Using this technique, he came to the conclusion that 4% is the highest percentage of the initial portfolio, indexed with inflation, which can be withdrawn without running out of money over a 30-year period.
More than 100 years of market data for a 60/40 portfolio puts the SWR for the UK at 3.7%.
In practical financial planning terms, the SWR is the inflation-adjusted percentage of the initial portfolio. It is designed like that to make sure the client will be able to maintain the buying power of their income during their retirement. But the SWR is designed based on the worse economic scenario in history. In fact, what is also important from a financial planning point of view is that in more than 80% of historical scenarios, after a 30-year period, the classical SWR would have resulted in a retiree actually having more money than they started with.
Using this model, it is likely that once the client is a few years into their retirement, it will become apparent that the higher withdrawal rate would be sustainable. For instance, take the case of a client who retires at 65 with a £300,000 pot and who is taking an inflation-adjusted withdrawal of £12,000 per annum. If that client finds themselves with a portfolio of £350,000 at the age of 75, most planners would consider it pretty sustainable to increase withdrawal to, say, £17,500 per annum.
The challenge, then, is to come up with a framework that enables clients to take a higher withdrawal rate, while having safeguards to prevent withdrawals from becoming unsustainable. The broad implication of all this is that the vast majority of people should be able to withdraw a higher proportion of their portfolios than they would using a broad-brush classical SWR calculation. The trouble is, on an individual basis, we do not know in advance whether clients are heading for a series of economic scenarios that would sustain a withdrawal rate higher than the generic SWR.
Without the proverbial crystal ball, how do we improve the income in retirement (over and above the ‘4% rule’), without risking clients running out of money or having to reduce their withdrawals significantly in the future?
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Guyton-Klinger decision rules
One method we can use to address this question is the Guyton-Klinger decision rules, designed to optimise withdrawal. They were created by a practising financial planner, Jonathan Guyton, principal of US firm Cornerstone Wealth Advisors, with the help of computer scientist William Klinger. These rules were originally published in the Journal of Financial Planning in 2006 and were replicated by Dr Wade Pfau, CFA in 2013.
The first two of its four rules are designed to make sure a sustainable withdrawal rate of about 5.5% is achievable over a retirement period of 40 years:
- The withdrawal rule: Increase withdrawal in line with inflation in the previous years, unless the previous year’s portfolio total return was negative. This is by far the most effective of the rules. By making sure that withdrawals are frozen in the years following a negative portfolio return, the danger of pound-cost ravaging is drastically minimised. Following the rule means clients do not ‘make up’ for missed withdrawal increases.
- 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 current withdrawal rate rises above 20% of the initial rate, then current spending is 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. Doing this means the client does not miss out on higher sustainable spending when markets are doing well.
The last two rules are designed as safeguards to stop the income the client slices away from their retirement pot becoming so high that the client risks running out of money, or so low that that their lifestyle is drastically reduced. These two rules are no longer applied within the final 15 years of the planned investment period.
By applying these rules, the client is able to increase the withdrawal rate to 5.5% of their initial portfolio (based on 65% equity allocation), without running out of money over a 40-year retirement period. Clients would have to freeze spending a few times over that period, but their overall spending power is not impaired because this is offset by the times in which they were able to increase withdrawal. By having a sound framework in place to manage withdrawals in a dynamic way, the risk of running out of money is significantly lowered.