What’s a ‘safe’ rate for drawdown and sustainable retirement spending?
A recently published white paper by Investec Structured Products looks at the ‘safe’ rate of drawdown and sustainable spending in UK retirement.
In its recent white paper, Investec Structured Products delved into the ground-breaking research of William Bengen and others, which assessed the ‘safe withdrawal rates’ for people taking money from their pension pots in retirement.
Bengen’s research is now 20 years old and looked at sustainable drawdown for a 30-year retirement period in which retirees could receive an income in line with inflation, without running out of capital. The figure he came to was 4%.
But as life expectancy continues to rise and market volatility becomes almost the norm, this paper asks whether a safe withdrawal rate (SWR) of 4% still a relevant basis for calculations?
Colin Brockman, of Investec Structured Products points out that Bengen’s study was based on US data, whereas in the UK, new work in 2010 by Wade Pfau concluded that even with perfect foresight of the best portfolio combination, the SWR was 3.77%, improving to 4.17% where a 10% probability of failure was acceptable.
Whatever the starting point, Brockman says, calibrating the right SWR invariably needs to be with the individual client’s needs and circumstances in mind, taking into account factors such as:
• their retirement time horizon
• likely changes in spending habits over the drawdown period
• any desire to leave a legacy
• the client’s attitude to risk
• the preferred asset allocation mix, and openness to diversification
• the impact of fees and taxes
• consideration of annuities and other products that could offer guarantees on income.
Also, the basis on which some of the calculations were made is changing. Notably, people are living longer than 30 years in retirement, and couples’ longevity is increasing too.
This affects the investment options, in line with the attitude to risk of the client. For optimal asset allocation, tradition suggests an increase in equity exposure for longer time horizons, and lower equity exposure for shorter periods. But for cautious clients who are keen to achieve 99% confidence levels, a sound approach might be to reduce the equity exposure to 30% or lower for any time horizon, as well as reducing the SWR, the paper proposes.
Other factors that have to be considered are that the older that people get, the less they tend to spend, reducing their income need in later life; and where retirement funds are invested, there may need to be more of a balance between spending and portfolio performance.
The paper refers to research by Guyton and Klinger in 2006, which found that clients who were prepared to adjust their income – reducing spending in difficult markets, and passing up inflation increases when markets were flat – could achieve the same overall lifetime spending, but at a starting level that was 20% higher, for example.
A similar trade-off between risk and equity exposure could see clients benefit from a higher initial SWR derived from a higher exposure to equities but with the acceptance that a greater possibility of investment failure, the more likely need there would be for an adjustment, and the more severe the potential adjustment could be.
Timing of first withdrawal
The paper flags that the main criticism of much SWR research is that it fails to account for the timing of the first withdrawal.
Just when a client takes their first payment and any subsequent market movements, can impact their starting balance – and so the income they can draw down using a set percentage rate. A fall in the markets in the year before retirement can seriously reduce the amount that can be withdrawn, long term.
One way around this, it is suggested, is to make clients who retire after a bear market eligible for a higher SWR, albeit on a lower balance, than those who retire before a market decline.
Other elements that have to be factored in are charges – advisers, providers and platforms – as well as the tax implications.
Increased complexity of retirement planning
The environment in which retirees now find themselves, including rising longevity, low annuity rates, low interest rates, a greater need to invest in the equity markets to deliver income, set against the client’s attitude to risk, make for a complex retirement planning scenario.
In addition, the Pension Freedoms legislation has now made far more attractive to pass on assets free from inheritance tax, using pension wrappers. This has made it more important for clients to retain their capital, both to help provide a sustainable income over an unknown period of time and to pass on a legacy to their beneficiaries.
Brockman argues that this is where structured products can be used to help deliver income and to add more certainty to the UK equity portion of a portfolio, thereby maintaining the capital from which that income is derived. Structured income plans offer the benefits of income guarantee, but within the framework of a drawdown portfolio, and can be tailored to fit each client’s risk appetite and individual circumstances, Brockman says.
In addition, the client retains control of the capital, unlike under other income guaranteed products like an annuity.
They can also boost SWR, he adds. For example, contingent income plans are available offering income levels of up to 7% and non-contingent plans, such as the Investec FTSE 100 Enhanced Income Plan, give a fixed monthly income of 0.42% per month, or 5.04% per annum.
The downside to the products are that capital is at risk should the benchmark index, in the case of the Investec plans, the FTSE 100, fall by 50% or more over the term – which would require the index to fall below 3,500 at today’s level – or the counterparty defaults.
The paper concludes that the complexity of retirement planning for ‘safe’ withdrawal rates means investors need the expertise of financial planner not only in initial retirement period but in order to monitor the variables continuously to ensure the portfolio stays on track to deliver a comfortable retirement and, more importantly, a sustainable one.
Read the white paper in full HERE.