Can you trust the ‘safe withdrawal rate’?

How much can you spend in retirement without worrying about running out of money?

To answer that most fundamental of questions, many financial advisers have traditionally relied on the concept of a ‘safe withdrawal rate’. Dating back to research conducted in 1994, this theory considers, as the name suggests, the rate at which it is safe to withdraw an income if the capital is to be preserved in the long-term.

The research shows that, assuming at least 50% is invested in equities, a 4% rate of withdrawal is ‘safe’.

Over the past 25 years or so, since the research was conducted, we’ve seen unprecedented times; the dotcom bubble, the financial crisis of 2008, Quantitative Easing, and the most prolonged period of low interest rates in modern times. It’s that final point which has arguably had the biggest effect: low interest rates, coupled with low yields on fixed interest assets, principally gilts and bonds, have curtailed the ability to produce an income from an asset class so beloved by those people searching for an income.

So, how much income is it safe to withdraw from your pensions and investments?

Until the introduction of pension freedoms, the amount you could take from your pension was dictated by annuity rates or was restricted by the Government Actuary’s Department (GAD) rates if you used income drawdown. However, in 2015 everything changed. The government gave us complete control of the amount we could take from our pensions.

With that responsibility comes the opportunity to retire early or even phase our way in to retirement, moulding our income to suit our needs. However, there is also the threat that if we take too much from our pension too soon, we may face a financially bleak old age.

Worryingly, there’s evidence to show that these threats may become a reality.

Research from Fidelity shows that nearly four in 10 would-be retirees have an unrealistically high expectation of the amount they can withdraw each year without harming their long-term financial security. Retirement Advantage has also found that many people underestimate their life expectancy by as much as eight years.

Twin aims

Most of our clients have two aims: firstly, to ensure that they can live the life they want in retirement, without running out of money. Secondly, to leave a financial legacy when they die.

The $64,000 question therefore is: how much can be safely withdrawn from pensions and other investments to achieve these twin aims?

As we’ve shown, received wisdom historically gave the answer at 4%; these days though, life isn’t so simple. As much as we’d like to give a precise answer, that’s sadly almost impossible simply because of the number of variables involved, including:

Inflation: The higher the rate of inflation, the larger the increases you will need to your income if you are to maintain its buying power. The higher those increases, the larger the change your capital will be depleted.

Life expectancy: The longer you live, the greater the burden on your capital. This is especially true for people who need care in later life, which can substantially increase the income needed.

Investment returns: Simplistically, the higher your investment returns the more scope you have for making withdrawals. Conversely, low returns, or significant reductions in the value of your capital due to stock market falls, will cut the amount you can safely withdraw if preservation of capital is your aim.

Returning to the original question.

It’s clear to us that the 4% rule, if not completely defunct, is living on borrowed time. That in itself isn’t particularly helpful, especially for those people who want to withdraw a ‘safe’ amount each year.

The answer is to develop a strategy based on prudent assumptions and underpinned by a robust investment approach which you believe will work. Then, review at least once a year and make alterations based on the available evidence.

Accessing pension benefits early may impact on levels of retirement income and is not suitable for everyone. You should seek advice to understand your options at retirement.