What is the ‘Safe Withdrawal Rate’ for your Pension?
You’ve decided it’s time to retire. You’ve been paying into your pension for many years and now want to stop working and focus on other aspects of life. But, how much of your pension pot can you withdraw each year without running out of money?
This is where the ‘safe withdrawal rate’ comes into play. We’ll explore how this rate works, whether it’s reliable, and what other factors you need to consider.
The pension landscape
When George Osborne’s pension freedoms came into force in 2015, they enabled retirees to flexibly access their Defined Contributions pensions from the age of 55 without tax penalties.
Until then, most people purchased an annuity, which was becoming a less attractive option due to falling annuity rates.
While the new regulations brought a welcome flexibility, some people found creating a sustainable retirement income daunting. Unfortunately, £30 million was lost to pension scammers between 2017 and 2020.
Some retirees were also over-enthusiastic in what they thought they could withdraw. From April 2021 to March 2022, the FCA found that 40% of withdrawals were taken at an annual rate of over 8% of the overall pension pot value, which was clearly not sustainable.
So, it’s important to have some guidelines.
How the 4% rule works
A ‘safe withdrawal rate’ is considered to be about 4% of your retirement balance, including your pensions and investments, which is adjusted for inflation each year.
In the early 1990s, William ‘Bill’ Bengen, an American aeronautical engineer turned financial adviser, decided to analyse historical market returns from 1926. He wanted to work out the highest withdrawal rate as a percentage of the initial investment pot that could be taken each year and adjusted for inflation without running out of money over a thirty-year retirement.
From his dataset, he arrived at the figure of 4% and called it the safe withdrawal rate (SWR). This became known as the 4% rule or Bengen rule, and it has been widely used by financial planners when discussing retirement options with clients.
A working example:
Brian and Sandra recently retired when Brian was 60, and Sandra was 55. They are working on a 30-year retirement window, with Brian dying at 90 and Sandra at 85.
Together, they have a pension pot of £1,000,000 and hope for a sustainable income of £40,000 per year.
This would be repeated every year.
For this example, we’ve not included any state pension or other factors such as taxation, care home fees, inheritances, downsizing, planning a gift to their children or leaving a legacy.
The Bengen rule helped bring simplicity to a complex area which had previously required a great deal of portfolio analysis.
But the 4% rule is just a rule of thumb. It’s not a one-size-fits-all solution, so you must assess whether it’s suitable for your personal circumstances.
Other factors to consider about the 4% rule
To adjust the 4% rule to your own situation, you will need to consider the following:
Where the ‘safe withdrawal rate’ can go wrong
The ‘safe withdrawal rate’ isn’t necessarily valid for UK retirees. It’s not an exact science, and UK investors can sometimes come off worse than their US counterparts due to underlying asset class returns or inflation.
In some cases, our couple Brian and Sandra might have only been able to take out a maximum initial starting withdrawal of £33,700 (3.37%) instead of £40,000 (4%) to avoid running out of money further down the road.
Or if they took 4%, their funds might have been empty after 21 years, i.e. 9 years short of the intended 30, in the historical worst-case scenario.
Remember, Bengen was only working with research up to 1992.
Adjust your ‘safe withdrawal rate’
While the ‘safe withdrawal rate’ of 4% may be a good starting point, it’s important to be flexible and keep monitoring your finances. Using a fixed rate can result in leaving behind more money than you intended, which some may find almost as undesirable as running out of funds during their lifetime.
So, assess how your retirement needs may change over time. Make sure you understand your investment portfolio and model different scenarios. Remember to factor in any tax you’ll have to pay.
You may have other incomes you can add to your pot. You may decide to change your retirement horizon to 45 from 30 and alter your spending throughout your retirement as your remaining life expectancy changes. And you may want some spending flexibility to make a large purchase or go on a dream holiday while you’re in good health.
Once you’ve taken all this into account, you can tweak your ‘safe withdrawal rate’ up or down.
Next steps
The key to a successful retirement is planning ahead, adjusting for changing circumstances, and regularly reviewing your withdrawal strategy so that your retirement savings will provide the income you need.
A ‘safe withdrawal rate’ is different for everyone, so get in touch with one of our experienced advisers, and we’ll help you create a personalised retirement plan that takes into account your goals and needs.
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