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The safe withdrawal rate and sequencing risk in retirement

For many years there has been discussion around the ‘safe withdrawal rate’. A lot has changed since 1994 so we will review to see whether the general rule of thumb still applies in today’s world.

Daisies on green nature background, stages of growth

by
Louis Coke

in Features

04.11.2019

For many years there has been discussion around the ‘safe withdrawal rate’. By this, we mean the rate at which an investor can erode their capital (for income in retirement, for example) at a ‘safe’ pace. That is to say, the funds should not run out before the longevity of the individual does! In 1994, US financial advisor William P. Bengen first articulated the idea of using 4% of starting capital as the ‘safe withdrawal rate’. However, a lot has changed since 1994 so we will review to see whether this general rule of thumb still applies in today’s world.

What affects the withdrawal rate?

There are several factors that affect the withdrawal rate that advisers and clients may wish to consider, as follows:

  • The age at which someone retires (or starts drawing on their funds)
  • Inflation and the consequent need to increase withdrawals (in notional £ terms) over time
  • Volatility of the investments in the portfolio
  • Tax – i.e. how much of the fund has to be eroded (gross) to give the client their (net) retirement income?

The safe withdrawal rate is also affected by the level of natural income a portfolio produces. For example, if a portfolio has a dividend yield of 1% and your client requires 4% per year, there is 3% that must be met by capital erosion. In a rising market, this is generally not a problem as the portfolio value is increasing however in times of falling markets, we have a negative compounding effect. This is sometimes referred to as ‘pound cost ravaging’.

On the other hand, a portfolio with a natural yield of 3% only requires 1% of capital erosion. This reduces the negative compounding effect significantly.

Does the safe withdrawal rate still work?

In his 2015 study, US adviser and blogger Michael Kitces showed that for investors taking 4% withdrawal and adjusted for inflation, most of the time the 4% rule works in that when the retiree has been drawing down on the pension for 30 years, there is still money in the pension pot. Some 2/3rds of the time, the client finishes the 30 year retirement time horizon with more than double their starting capital. In fact, the study shows that less than 10% of the time the retiree finishes with less than the starting principal amount. (Important note: this is assuming a 60/40 equity:bond portfolio)

Investing for income versus Total Return

From the above analysis you may be tempted to look at portfolio options that carry an attractive level of natural (dividend) income. This is a very valid choice for some clients however one must appreciate that investing for income does require some skill to avoid ‘dividend traps’ and unsustainable levels of income. In times when growth-focused investments look attractive, there may be some relative underperformance from an income orientated strategy. However, the inverse is also true- when economic and profits growth is scarce, a portfolio of income-generating assets can outperform the wider market as these investments tend to look attractive for their defensive qualities.

As with many decisions in investing, there is no obvious right or wrong answer to which strategy is best. However, a measured approach and a good understanding of the merits of both approaches is a very good start for the conversation. The focus on either total return or investing for natural yield also has an impact on potential sequencing risk, as noted below.

Sequencing Risk

One of the issues with taking the average long term market returns and aiming for withdrawals less than this long term average is that when there are the inevitable negative years, the withdrawals actually compound the erosion of the portfolio. If these negative years are clustered around the early years of drawing down on a portfolio, this can erode the capital value to such a point that the fund will be exhausted. This is known as ‘Sequencing Risk’.

In a great blog post, the US Financial Advisor and blogger Michael Kitces analysed how the 4% safe withdrawal rate had held up since the tech bubble of 2000 and the financial crisis of 2008. You can see the full blog post here.

The findings are rather startling and should serve as a useful guide to the effect that returns in the early years of retirement can have on the longevity of a retirement portfolio. In a further post, Kitces notes the correlations between the safe withdrawal rate and various timescales. The key to this is that the first decade of retirement seems to have the most significant effect on whether the conventional 4% safe withdrawal rate is appropriate.

When we think logically about this, it makes sense. A bad market in the first or second year of a retirement portfolio may not be too damaging as the portfolio is still relatively large for when the market begins to rise again and can therefore benefit from the subsequent rise in asset prices. Similarly, a bad market when the portfolio has been paying out income for a long time (20 years let’s say) is potentially less damaging because the portfolio has paid out a significant sum of money already and the income time horizon required is reducing. The real driver of sequencing risk is the real (i.e. inflation-adjusted) returns achieved over the first decade of retirement.

There is also the question of where the withdrawals are funded from. In good markets it may make sense to reduce the equity content and in bad markets, it may be most prudent to realise funds from fixed income or alternative assets. At this point the relationship and lines of communication between the financial adviser, discretionary fund manager (if used) and client are key. We find that this discussion can offer real added value to the client and can make a meaningful impact on the longevity of their pension fund.

Conclusion

In conclusion, we have established a few main points for consideration:

  • The 4% rule still seems to work when looking at historical scenarios, although it is very dependent on the inputs (time horizon, tax, risk)
     
  • Sequencing risk in the first 10 years of retirement is arguably the most important driver of establishing whether a fund will last for the duration of retirement
     
  • There is no ‘formulaic’ response to managing safe withdrawals and sequencing risk- this should form part of the adviser’s ongoing dialogue with the client and any other providers (i.e. discretionary fund manager)

Whilst we are primarily looking at pensions in retirement in this article, the same logic could be applied to other cases. For example, life interest trusts seeking to produce a return for a life tenant and a degree of long term capital growth for the remaindermen.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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