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The 4% rule offers an answer to one of retirement’s hardest questions: how much can I safely spend? But markets don’t move in straight lines and it’s likely that the plans you have for your retirement won’t either. Could being prepared to vary your income help your pension last longer?
One of the biggest challenges when moving from saving for retirement to spending your pension is deciding how much you can afford to take out.
A popular rule of thumb when it comes to how much you might be able to withdraw in retirement is the 4% rule. Move into an option like drawdown with £500,000, for example, and you withdraw £20,000 in your first year. In subsequent years you increase that £20,000 by inflation rather than recalculating 4% of whatever your portfolio is now worth.
The rule has its origins in research published by US financial planner William Bengen in 1994. Using historical US investment returns, Bengen examined how different starting withdrawal rates and asset allocations survived over retirement. The beauty of this rule is that it’s simple to understand, but like many rules of thumb, it doesn’t reflect your personal circumstances, including your portfolio mix.
The order and timing of withdrawals matters
One of the biggest threats facing investors drawing an income is sequencing risk.
Imagine suffering a 20% market fall. During your working life it is undoubtedly uncomfortable, but if you are still contributing to your pension and other investments, you might have plenty of time to wait for markets to recover and you might even benefit if you’re adding to your investments when prices are cheaper.
But then imagine the same fall immediately after retiring. This could have big consequences if you need to sell investments to finance your living expenses while prices are depressed. This depletes your invested assets more quickly than planned and also leaves less invested overall to participate in the eventual recovery.
Two retirees experiencing similar average investment returns during retirement could have very different outcomes depending upon when the good and bad years occur.
Should your income ignore the markets?
It’s worth considering this in the context of the 4% rule. If your £500,000 portfolio falls to £400,000, you don’t recalculate your income as 4% of £400,000. You continue taking the original £20,000, increased by inflation.
This is handy for budgeting, as your income is relatively predictable, but your portfolio has to absorb the consequences.
An alternative is to adjust your spending to absorb some of the volatility instead.
At its simplest, you could withdraw a fixed percentage of your portfolio each year. Your chances of completely exhausting the fund may be reduced, but your income could fluctuate dramatically and not give you the lifestyle you’d planned for in retirement.
Another approach is a variable withdrawal strategy, sometimes labelled dynamic spending or a guardrails strategy where limits are placed on the changes in annual spending. Withdrawals can rise when investments are performing well and might fall following poor returns, but the floor and ceiling guardrails prevent spending power moving quite as dramatically as a fixed percentage strategy.
Two retirees walk into a bear market...
So, what difference might that make? Let’s consider an example of two investors, each starting retirement with £500,000 invested in identical portfolios.
Both withdraw £20,000 in their first year, but markets hit a bumpy patch, and it particularly impacts their investments. Their investments fall by 20% in year one followed by a further 10% fall in year two, before recovering in later years.
Investor A follows a traditional 4% strategy, increasing the original £20,000 withdrawal by an assumed 2.5% inflation each year.
Investor B follows a more flexible approach. They target 4% of their portfolio’s value but limit any annual reduction or increase in their cash withdrawal to 5%.
At first glance, it seems like investor B has a better outcome. After 10 years they have around £390,000 remaining, compared with approximately £326,000 for investor A.
But the picture changes when you consider what they were able to spend. Investor A received approximately £224,000 gross over the decade, compared to investor B receiving only around £170,000 gross.
Investor B protected their overall portfolio but effectively accepted a lower income to the tune of £54,000 over the decade to do so.
This simple example shows that a variable withdrawal strategy doesn’t necessarily mitigate sequencing risk or make one investor wealthier than another overall. In practice it can transfer some of the risk from your portfolio to your lifestyle because income may need to fall after poor market returns.
Another risk that is often overlooked is being too cautious. You might successfully avoid running out of money only to reach later life with a substantial untouched portfolio and realise you could have afforded more holidays, experiences or gifts to your family while you were younger and healthier.
How flexible can you be?
Deciding how much income to take in retirement involves balancing competing priorities and goals. What some people might group into essential spending might also differ, as well as the priority placed on other goals such as leaving an inheritance or a charity legacy.
A useful exercise when calculating your target income is to separate different types of spending into groups, as you would when creating a budget. One group might include essentials such as food, housing, energy and council tax but be separate from discretionary expenditure on holidays, restaurants, cars and gifts.
You might find that some of those essential expenses could eventually be covered by secure income such as the state pension. Someone whose essential bills are largely covered by secure income may have much greater freedom to trim investment withdrawals after a market crash.
No rule can be regarded as a guaranteed strategy. Even securing your income with an annuity comes with its own considerations and risks. How much you can safely spend depends on how long your retirement lasts, the investment returns you achieve, inflation, fees, tax and any other income sources. But one of the most important questions is how willing you are to change your spending when circumstances change. The trade-off is between certainty today and greater income security later in life.
Charlene Young: Head of Technical
Charlene joined AJ Bell in 2014 from a wealth management firm where she worked with private clients and small businesses as a financial planner.
Charlene has over 15 years’ experience in financial services, holding Chartered...