For clients in retirement, developing a sensible and sustainable withdrawal strategy is at least as important as developing a sensible investment strategy. Unless a client annuitises all or most of their retirement pot, they need to have a robust framework in place to guide their withdrawal decisions or risk running out of money.
From April 2015, clients in pension drawdown will bid farewell to GAD rates (for the most part), and other restrictions on access to their pension funds. For many clients, the question simply will be – how much am I able to draw out of my pension pot without the risk of running out of money during my lifetime?
In 1994, US financial planner William Bengen famously postulated the 4 percent withdrawal rule using historical simulations. He would later coin the term “SAFEMAX” to describe the highest withdrawal rate, as a percentage of the initial account balance at retirement, which could be adjusted for inflation in each subsequent year and would allow for at least 30 years’ withdrawals during all the rolling historical periods in his dataset. He found that a first year withdrawal rate of 4%, followed by inflation-adjusted withdrawals in subsequent years, should be ‘safe’.
Some practitioners feel the 4% rule is rather naïve, as it ignores the dynamic nature of market and portfolio returns. More recent research has sought to determine the optimal withdrawal strategy by dynamically adjusting to market and portfolio conditions.
How would Bengen’s research have applied in a UK context? Luckily, in 2010, Wade Pfau replicated Bengen’s research in 17 developed countries including the UK. Pfau’s initial research used 109 years of financial market data (between 1900 and 2008) for the 17 developed market economies, using domestic asset classes and currencies. With this data, he used an historical simulations approach, considering the prospect of individuals retiring in each year of the historical period. Because of the assumed retirement duration of 30 years and the data ends in 2008, retirements take place between 1900 and 1979 – i.e. 80 retirement dates for each of 17 countries.
So what does the data tell us about safe withdrawal rates for UK retirees? Sadly it’s not good news.
Pfau determined that even with perfect foresight of the best combination of UK equities and bonds (a concept that is unrealistic in real life), SAFEMAX for UK is 3.77%. If a client is prepared to accept a 10% probability of failure however, the SWR improves to 4.17%. At a 5% withdrawal rate however, the probability of failure is 27.5%.
Since the concept of perfect foresight is wishful thinking, Pfau’s results for a 50/50 portfolio puts SAFEMAX at 3.43%. But if a 10% probability of failure is acceptable, then the SWR is 4.01%. Interestingly, a withdrawal rate of 5% has a failure rate of a whopping 55.6%! Pfau later revisited the research to see if global diversification improves the SWR. He found that with a 50/50 portfolio the SAFEMAX is 3.26% and where a 10% failure rate is acceptable, the SWR rate is 3.55%. This indicates that the SWR actually worsened for UK retirees.
The table below summarises the findings:
Perhaps worryingly, Pfau’s research assumed fund charges and the adviser fee to be 0%. This is of course unrealistic, and if we were to deduct a conservative fee to account for the adviser fee, fund and platform charges, SWR for UK would be closer to 2% than 4%! (And around 3% for a 30% failure rate).
Join us at the Retirement Income Conference, where leading US financial planner Michael Kitces will explore latest research on Safe Withdrawal Rates in retirement portfolios.