One of the most important financial planning challenges of the 21st century is to help clients make sure their pension pot lasts a finite, albeit precisely unknown, period in retirement. Simultaneously, we want to prevent inflation, the thief that keeps on taking, from depleting the buying power of their income over what may be a 25, or possibly 30-year retirement. Face it, retiring clients want to have their cake and eat it. They want the security of an annuity and the flexibility of drawdown.
Safe withdrawal rate
Nearly 20 years ago, in an attempt to help address this challenge, the popular ‘4% rule’, otherwise known as ‘safe withdrawal rate’ (SWR), was developed by US-based financial planner (now retired) Bill Bengen.
Bengen simulated timelines for simple stock and bond portfolios over several 30-year periods, starting from 1929. Using this technique, he came to the conclusion that 4% is the highest percentage of the initial portfolio, indexed with inflation, which can be withdrawn without running out of money over a 30-year period. More than 100 years of market data for a 60/40 portfolio puts the SWR for the UK at 3.7%.
UK safe initial withdrawal rates by starting year with a 60% equity portfolio
Source: Michael Kitces (2015)
How ‘safe’, though, is the safe withdrawal rate? The answer is pretty safe. SWR is based on the worst economic scenario that we have seen in market history over the past 100 years, which includes retiring through the depression of 1929 to 1939, which is the longest, deepest, and most widespread depression of the 20th century.
In the UK, the SWR is based on retirement starting in the mid-1930s, just as the effects of the
Great Depression had peaked and the UK had come off the gold standard. Britain’s world trade fell by half (1929-33), and unemployment reached 70% in some areas (more than 3.5 million were unemployed nationally, while many more had only part-time employment).
In short, the SWR is designed to withstand an economic climate of such severity that any future market conditions would need to be worse than any we have ever seen in history for its withdrawal model to become unsustainable.
What is more, for there to be market conditions that would warrant the failure of the SWR model, the meltdown would have to be on such a scale that it would probably entail the collapse of the insurance companies that provide guarantees on retirement income and annuities. Were financial armageddon on that scale ever possible, the Financial Services Compensation Scheme itself would probably go belly-up.
In practical financial planning terms, the SWR is the inflation-adjusted percentage of the initial portfolio. It is designed like that to make sure the client will be able to maintain the buying power of their income during their retirement.
We already know it can withstand a worst-case scenario. What is also important from a financial planning point of view is that in more than 80% of historical scenarios, after a 30-year period, the classical SWR would have resulted in a retiree actually having more money than they started with.
Using this model, it is likely that once the client is a few years into their retirement, it will become apparent that the higher withdrawal rate would be sustainable.
For instance, take the case of a client who retires at 65 with a £300,000 pot and who is taking an inflation-adjusted withdrawal of £12,000 per annum. If that client finds themselves with a portfolio of £350,000 at the age of 75, most planners would consider it pretty sustainable to increase withdrawal to, say, £17,500 per annum.
The first decade of retirement is crucial to how the rest of it will play out financially. Research has shown a very strong correlation between the returns in the first decade of retirement and the sustainable withdrawal rate over a 30-year retirement period.
Aiming for higher withdrawals
The challenge, then, is to come up with a framework that enables clients to take a higher withdrawal rate, while having safeguards to prevent withdrawals from becoming unsustainable.
The broad implication of all this is that the vast majority of people should be able to withdraw a higher proportion of their portfolios than they would using a broad-brush generic SWR calculation.
The trouble is, on an individual basis, we do not know in advance whether clients are heading for a series of economic scenarios that would sustain a withdrawal rate higher than the generic SWR.
Without the proverbial crystal ball, how do we improve the income in retirement (over and above the ‘4% rule’), without risking clients running out of money or having to reduce their withdrawals in the future?
Guyton-Klinger decision rules
One method we can use to address this question is the Guyton-Klinger decision rules. This set of rules is designed to optimise withdrawal. Applied together with the SWR, these rules bring a bespoke touch to a withdrawal plan. They were created by a practising financial planner, Jonathan Guyton, principal of US firm Cornerstone Wealth Advisors, with the help of computer scientist William Klinger.
The first two of its four rules are designed to make sure a sustainable withdrawal rate of about 5.5% is achievable over a retirement period of 40 years:
The withdrawal rule
Increase withdrawal in line with inflation in the previous years, unless the previous year’s portfolio total return was negative. This is by far the most effective of the rules. By making sure that withdrawals are frozen in the years following a negative portfolio return, the danger of pound-cost ravaging is drastically minimised. Following the rule means clients do not ‘make up’ for missed withdrawal increases.
The portfolio management rule
Extract the gains from an asset class that has performed best in the previous year to provide the income, and move excess portfolio gains (beyond what is needed for the withdrawal) into a cash account to fund future withdrawals.
The next two rules are designed as safeguards to stop the income the client slices away from their retirement pot becoming so high that the client risks running out of money, or so low that that their lifestyle is drastically reduced. These two rules are no longer applied within the final 15 years of the planned investment period.
The capital preservation rule
If the current withdrawal rate rises above 20% of the initial rate, then current spending is reduced by 10%.
The prosperity rule
Spending in the current year is raised by 10% if the current withdrawal rate has fallen by more than 20% below the initial withdrawal rate. Doing this means the client does not miss out on higher sustainable spending when markets are doing well.
By applying these rules, the client is able to increase the withdrawal rate to 5.5% of their initial portfolio (based on 65% equity allocation), without running out of money over a 40-year retirement period. Clients would have to freeze spending a few times over that period, but their overall spending power is not impaired because this is offset by the times in which they were able to increase withdrawal. By having a sound framework in place to manage withdrawals in a dynamic way, the risk of running out of money is significantly lowered.
Abraham Okusanya is director of FinalytiQ