How much should I take out of my pension?

Having spent your career building up a pot of money for later in life, the last thing you want to do is run it down quickly in retirement. There is a balancing act between spending enough to enjoy life and not being too excessive.

Withdrawing 4% a year uprated in line with inflation used to be a popular strategy, but that is now up for debate. People are living longer, which means retirement pots must go a little further. There isn’t a one-size-fits-all approach, and investors need to be fluid rather than following a rigid spending plan.

Lots of factors influence withdrawal amounts, from age, to health, to whether your money is supporting just yourself or a partner as well. Wealth can also be distributed across multiple assets beyond a pension so any retirement plan needs to consider different ways spending could be funded.

You also need to factor in whether you want to pass down wealth at death or spend everything while you’re still alive.

Understanding your income needs

A person living on their own might need £32,700 a year to enjoy a moderate retirement lifestyle or £45,400 for a comfortable one, according to Pensions UK’s latest estimates which assume people own their home outright and do not factor in the amount of top of this sum that would need to be paid in income tax. A couple might together need £45,400 a year for a moderate standard of life or £62,700 for a comfortable one.

The state pension can play an important role in helping meet these goals, but many people retire before they are old enough to start receiving it. You’ll need to factor that situation into your cash flow planning.

How withdrawals might work in practice

Let’s run through an example of a single person, called Linda, who retires at age 60 and won’t receive the State Pension for another seven years. Linda has a £400,000 pension pot and can withdraw one quarter of the pot tax free (£100,000).

For the years leading up to State Pension age, Linda decides to withdraw 9% annually, uprated by 2% inflation each year. Based on these withdrawal rates and 5% annual investment growth after charges, she would collect £36,000 in year one, rising to £40,542 in year seven. Note that her £100,000 tax-free limit would be used up during year three, so income tax would need to be factored in from this point.

After seven years, Linda would have £237,238 left in her pension pot and she decides to lower the withdrawal rate to 6%, still uprated by 2% inflation each year. She also can now top up her income with the State Pension. Assuming the same 5% annual investment growth, Linda’s personal pension would run out after 23 years when she is aged 90. She would still have an income source from the State Pension should she live longer, but it would be a fraction of her spending from before which could mean a big change in lifestyle.

What is the 4% rule?

The 4% rule suggests withdrawing 4% of your pension in your first year of retirement, then adjusting that amount yearly for 2% inflation, to help your savings last for 30 years. This is a rule of thumb as there is no guarantee the money will last this long.

It originates from an idea in 1994 by US financial planner William Bengen who studied historical market performance from a portfolio half in stocks and half in bonds.

 

Downside of spending too much too early

Many people spend more in the early years of retirement while they're still healthy and active, with spending often falling as they get older. Yet there are risks with front-loading withdrawals from a personal pension.

If the stock market falls in the early stages of retirement and you’re taking out large sums from your personal pension, there is a risk your pot is depleted faster than expected. Bills don’t stop in a bear market, and regular withdrawals amplify the damage.

Not every year is likely to be positive for the market, hence the need to keep revisiting your cash flow plan to prepare for any future investment volatility.

Different income strategies

Many investors would love to live solely off dividend income from their portfolio – known as a ‘natural yield strategy’. Assets wouldn’t have to be sold in down markets, and this approach can reduce emotional and behavioural risk. Unfortunately, this strategy might not generate a sufficient income, and dividend growth might lag the pace of inflation so your cash wouldn’t go as far.

An alternative approach is to follow the so-called ‘bucket strategy’. You divide your portfolio into three buckets. Bucket one contains low-risk assets such as money market funds, and this covers the next two years’ worth of spending. Bucket two features medium to higher risk assets, such as developed market equity income funds, to generate cash flow to replenish bucket one. Bucket three has high risk assets and aims to generate long-term capital growth and help top up bucket two.

Valuable lessons

This isn’t a plan to put into motion and forget. It is important to rebalance buckets from time to time. Classic mistakes including over-allocating money to bucket one thinking that’s the safe thing to do, or mistakenly putting too risky of assets into bucket one and suffering when there is a market downturn.

There is no single rule that safely manages retirement withdrawals on its own. Instead, you need to be flexible and be prepared to check in at least once a year to see if your plan still works for you.