17 September 2020
With growing numbers of people reaching retirement with a pension pot to manage rather than a regular guaranteed income, there is a growing need for savers to understand how rapidly they can draw on that pot without risk of running out of money. For the last two decades, the most widely used ‘rule of thumb’ has been the 4% rule – the assumption that for most people, drawing at a rate of 4% of the original pot, increasing each year in line with inflation, should be a sustainable approach.
But new analysis by consultants LCP – “How QE broke the 4% rule” - finds that the era of ultra-low interest rates, reinforced by Quantitative Easing (QE), means that a 4% drawdown rate is no longer likely to be sustainable for many people.
The new report ‘How QE broke the 4% rule’ uses a simulation model to assess the sustainability of different withdrawal rates in current market conditions, and tests how far this is affected by the asset mix of the pension pot and by charging levels.
The 4% rule has already been extensively analysed, but
- Sharp changes in market conditions means work done even 4 or 5 years ago needs to be updated
- Investment and adviser charges are often not fully factored in
- Much analysis focuses on the US and needs to be updated for UK market conditions
Key findings are:
- Sticking to a 4% rule is three times more likely to lead to failure (ie running out of money) than in the market conditions of a decade ago and taking account of increased longevity;
- A combination of high charges (for advice and for investment products) and low-risk investment is ‘the worst of all worlds’; current headline rates of return on low risk investments are so low that a combination of inflation and fees eat away rapidly at the pot and lead to a high risk of running out of money prematurely;
- Advice fees and other costs and charges are in many cases *more* important than asset allocation as determinants of sustainable withdrawal rates; in some cases, the report finds that the ‘adviser earns more than your investments do’ over the course of a retirement;
- There is a strong case for considering higher risk investing in retirement, supported by good value advice; despite the greater risk, the modelling finds that this approach can support a higher withdrawal rate in most scenarios than a very conservative approach, especially where there are advice fees as well;
The report also looks at ways to modify the ‘4%’ rule – which assumes constant annual real terms withdrawals - to reflect current market conditions. These could include:
- A lower steady rate of withdrawal – broadly speaking, the calculations which led to the 4% rule two decades ago would imply a steady withdrawal based on 3% of the original pot plus inflation;
- Keeping the cash level of withdrawal constant, rather than increasing for inflation; although this implies a modest real terms decline in annual withdrawals on this part of total income (although other elements such as state pension will continue to match or beat inflation) this allows savers to gradually adjust their spending patterns and to reduce their chance of running out of money; it may be preferable to a more dramatic adjustment later in retirement if investments under-perform;
- Acknowledging that spending in retirement can often follow a ‘smile’ shape – with higher spending amongst younger and more active retirees, gradually reducing as people age, but then rising in later life as care costs start to increase; planning withdrawals on this basis could better match when the retiree is going to need the money and avoids under-consuming early in retirement;
The report has a number of recommendations:
- For individuals
- Not to rely on a simple ‘4% principle’ as a basis for drawing on their pension pot;
- To ensure that they are not combining relatively high costs and charges with a risk-averse investment strategy, as this combination could be ‘the worst of all worlds’; taking more risk, appropriately advised, could be a better approach;
- To consider planning their retirement spending in more flexible ways than a constant real terms withdrawal;
- For wealth managers and the financial services industry
- To review whether fee levels have adjusted sufficiently to reflect the new environment of low interest rates and low inflation;
- To consider whether investment portfolios are taking sufficient risk;
- To come up with low-cost and innovative products which help savers to manage their money in drawdown in an era of low returns;
- For government and regulators
- To support and incentivise those who are willing and able to work beyond traditional retirement ages, thereby enabling them to build up a larger initial pension pot which is drawn down for a shorter period;
- To bear down on costs and charges in retirement, as these have such a powerful influence on investor returns.
Commenting, Dan Mikulskis, partner at LCP said:
“Too much discussion around managing a pension pot in retirement is based on a world which no longer exists. With negative real interest rates and longer retirements, paying high charges to invest cautiously can greatly increase the risk of running out of money. Those who are set to be retired for 25-30 years should, still consider investing a significant part of their retirement pot for growth. Old rules about ‘sustainable’ withdrawal rates are now dangerously unsustainable and need to be revisited”.