For people in retirement, or about to retire, developing a sensible and sustainable withdrawal strategy is as important as developing a sensible investment strategy. Many soon to be pensioners often ask What is a Safe Withdrawal Rate in Retirement ?
Establishing how much can reasonably be withdrawn from a pension fund while ensuring that the fund lasts your entire lifetime, and that the purchasing power is not eroded by inflation, is therefore an important part of the pension planning process.
The Safe Withdrawal Rate Origins
The safe withdrawal rate is a method developed in the US over 20 years ago. Historical simulations were used over several 30-year periods starting from 1929. The conclusion was that the safe withdrawal rate is 4%, i.e. 4% is the highest percentage of the initial portfolio adjusted for inflation each subsequent year, which can be taken without running out of money over any 30 year period.
A similar study based on UK market data of over 100 years, assuming a portfolio with 60% in equities, put the safe withdrawal rate for the UK at 3.7%. The results for a portfolio with 50% in equities, put the safe withdrawal rate at 3.4%.
The time periods considered in the UK study included some very severe economic conditions. The safe withdrawal rate has been designed to withstand an economic climate of such severity that any future market conditions would need to be worse than any that have been seen in history, for its withdrawal model to become unsustainable.
Safe Withdrawal Rate Foundation
An understanding of the safe withdrawal rate provides a useful foundation on how to best ensure that your retirement fund does not run out during your lifetime.
It does need to be remembered that this is simply a handy guide which needs to be adopted for each person’s individual circumstances. Read what is a pension here.
Consider the following safe withdrawal rate examples,
The safe withdrawal rate assumes a period of 30 years in retirement. This sounds like a long period, but if we are considering a couple who have both reached age 65, there is a 17% chance that one of them will reach 100.
The safe withdrawal rate is sensitive to asset allocation, so what is an acceptable rate for you, needs to be adapted to reflect each persons attitude to risk.
While the safe withdrawal rate is a useful starting point, research has shown that the likelihood of the fund not being depleted during retirement can be improved by dynamically adjusting withdrawals to market and portfolio conditions.
For example by:
Forgoing annual inflation adjustments in years following a poor market return;
taking a fixed percentage of the portfolio value as opposed to an inflation adjusted amount based on the initial portfolio size;
taking income withdraws from the asset classes that have experienced the most growth.
Whatever cash flow strategy you take should be stress tested regularly and the following should be considered as part of that stress test.
Sudden or permanent loss of assets, eg business failures, stock market crash
The need to increase the income taken from a portfolio
The need for a large ad hoc withdrawal
future inflation is higher than historically expected
Living longer than expected,
Future returns are lower than expected
Safe Withdrawal Rate in Retirement Conclusion
The outcomes should be discussed and considered so that you can decide whether or not you will be able to take the income you require from the fund, and in answering the question asked earlier, What is a Safe Withdrawal Rate in Retirement, does this actually fit your needs in retirement or do you need to make further provisions?