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Retirement planning: Better safe than sorry … and skint

In this extract from his recent white paper, Abraham Okusanya examines the means to determine a sustainable income withdrawal strategy for clients in retirement

For clients in retirement, developing a sensible and sustainable withdrawal strategy is at least as important as developing a sensible investment strategy. Unless a client annuitises all or most of their retirement pot, they need to have a robust framework in place to guide their withdrawal decisions or risk running out of money.

Experience from the US: The ‘4% Rule’

Across the pond in the US, where retirees have had virtually unrestricted access to their retirement fund for several years, there is an extensive body of research aimed at helping financial planners and clients implement a sustainable withdrawal strategy in retirement. The foundation for this work lies in understanding ‘Safe Withdrawal Rates’ (SWR), which has its origins in the work of a now retired financial planner, William Bengen.

In 1994, Bengen famously postulated the 4% withdrawal rule using historical simulations. He would later coin the term ‘SAFEMAX’ to describe the highest withdrawal rate, as a percentage of the initial account balance at retirement, that could be adjusted for inflation in each subsequent year and would allow for at least 30 years’ of withdrawals during all the rolling historical periods in his dataset. He found that a first year withdrawal rate of 4%, followed by inflation adjusted withdrawals in subsequent years, should be safe. Cooley, Hubbard, and Walz (1998) used a Monte Carlo simulation based on the same data to determine that a 4% withdrawal rate with an underlying portfolio of 50% stocks and 50% bonds provides a 95% chance of success.

Some experts and practitioners feel the 4% rule is rather naïve, as it ignores the dynamic nature of the market and portfolio returns. More recent research has sought to determine the optimal withdrawal strategy by dynamically adjusting to market and portfolio conditions.

Is the 4% Rule ‘safe’ for UK retirees?

Most of the work on safe withdrawal rates has been generated using US financial market data. How would Bengen’s research have applied in a UK context? Luckily, in 2010, Wade Pfau, a Professor of Retirement Income at The American College of Financial Services, replicated Bengen’s research in 17 developed countries including the UK.

Pfau’s initial research used 109 years of financial market data (between 1900 and 2008) for the 17 developed market economies, using domestic asset classes and currencies. With this data, he used an historical simulations approach, considering the prospect of individuals retiring in each year of the historical period. Because of the assumed retirement duration of 30 years and the data ends in 2008, retirements take place between 1900 and 1979 – i.e. 80 retirement dates for each of 17 countries. Pfau’s results provide guidance to prospective retirees in 17 different countries as to what a sustainable withdrawal rate in their portfolios is likely to be. So what does the data tell us about safe withdrawal rates for UK retirees? Sadly it’s not good news.

Pfau determined that even with perfect foresight of the best combination of UK equities and bonds (a concept that is unrealistic in real life), SAFEMAX for UK is 3.77%. If a client is prepared to accept a 10% probability of failure, however, the SWR improves to 4.17%. At a 5% withdrawal rate, the probability of failure is 27.5%.

Since the concept of perfect foresight is wishful thinking, Pfau’s results for a 50/50 portfolio put SAFEMAX at 3.43%. But if a 10% probability of failure is acceptable, then the SWR is 4.01%. Interestingly, a withdrawal rate of 5% has a failure rate of a whopping 55.6%! Pfau later revisited the research to see if global diversification improves the SWR. He found that with a 50/50 portfolio the SAFEMAX is 3.26% and where a 10% failure rate is acceptable, the SWR rate is 3.55%. This indicates that the SWR actually worsened for UK retirees.

The table below summarises the findings:

Chart - Abraham White Paper

Source: Wade Pfau (2010, 2014) Assumptions include perfect foresight/fixed 50/50 domestic equities/bond allocation/fixed 50/50 global equities/bond allocation, a 30-year retirement duration, no administrative fees, annual inflation adjustments for withdrawals, and annual rebalancing.

Perhaps worryingly, Pfau’s research assumed fund charges and the adviser fee to be 0%. This, of course, is unrealistic, and if we were to deduct a conservative 1.2% from the percentage withdrawal to account for the adviser fee, fund and platform charges, SWR for UK would be closer to 2% than 4%! (And around 3% for a 30% failure rate).

Personalising SWR to clients

An understanding of the SWR provides a useful foundation for advising clients on how best to ensure their retirement pot doesn’t run out before they do. However, it is a rule-of-thumb and needs to be adapted to account for each client’s individual circumstances. This can be achieved through the use of Monte Carlo models, taking account of each client’s risk profile, asset allocation, expected life expectancy and tolerance of the probability of failure.

It is especially important to bear in mind the following factors when working with clients to establish a personalised SWR:

• Probability of failure & magnitude of failure: Sustainable withdrawal rates will vary for each client because it is sensitive to what probability of failure (PoF) is acceptable to the client. Generally, a PoF of 10-30% would be acceptable but each client differs in terms of what they feel comfortable with.

• Life expectancy; Most research into SWR assumes a period of 30 years in retirement. Financial planners and their clients have to engage in an informed conversation about whether they consider this conservative enough. This is particularly relevant when planning for couples, as data from the National Office of Statistics shows that a couple who are both aged 65 has a 25% chance of one of them reaching age 97 and a 17% chance of one of them reaching age 100! So maybe 30 years is not robust enough for some clients after all?

• Asset allocation: A SWR is sensitive to asset allocation, and accordingly it needs to be adapted to reflect each client’s risk profile and the recommended asset allocation.

• Flexibility of withdrawal/spending: A SWR as defined by Bengen and Pfau in their research assumes that clients withdraw a percentage of the initial portfolio and adjust it for inflation every year. It doesn’t account for clients’ preparedness to adjust withdrawals in bad or very good years. A greater degree of flexibility in spending improves the probability of success.

Dynamically adjusted withdrawals

Research has shown that the success in retirement can be improved by dynamically adjusting withdrawals to market and portfolio conditions. These dynamic approaches can offer a more realistic path that retirees are more likely to follow, as they continually “adapt” to the on-going returns of the portfolio. But, how exactly should retirees adjust their spending patterns in response to changes in the value of their portfolios?

There are countless flexible spending approaches, and it’s important for advisers to understand the pros and cons of each approach and have a framework in place for guiding clients. This can ensure that wealth will not run out, though it provides no protection against painfully low levels of spending. The most commonly used strategies that advisers can apply to managing client portfolios include (but are not limited to) the following:

• Foregoing annual inflation adjustments in years following a poor market return.

• Constant Percentage Approach, where withdrawals are based on a fixed percentage of portfolio value, as opposed to an inflation adjusted amount based on a percentage of the initial portfolio size.

• Portfolio Management Rule, which focuses on attempting to make withdrawals from asset classes which have experienced the most growth.

This is an area where ongoing financial planning comes into its own; when clients become aware of the invaluable work that their advisers do to ensure that they don’t run out of money before they run out of time. Of course, it is equally important to ensure that clients aren’t underspending and facing the risk of dying with too much money – having not enjoyed the best possible lifestyle that they could have.


This is an extract from the white paper: Pound Cost Ravaging. Understanding Volatility Drag, Sequencing Risk and Safe Withdrawal Strategy In Retirement Portfolios. For access to the full white paper CLICK HERE.

For details of FinalytiQ’s Retirement Income conference CLICK HERE




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