When it comes to choosing a safe pension withdrawal rate you may have heard that taking 4% a year from your pension is the thing to do.
This may be OK if everything always stayed the same e.g. your spending, inflation and investment growth.
But unfortunately nothing stays the same and therefore it’s important you know what you can and can’t control before you decide on what pension withdrawal rate is safe for you.
At the point you give up work there are some decisions to be made about how you are going to replace the income you were earning through your job.
If you have paid enough National Insurance contributions during your working life, you will receive the State Pension, albeit not until 65+.
You may also be fortunate enough to still be part of a defined benefit pension scheme, otherwise known as a final salary pension.
Both of the above will pay you a guaranteed income, usually increased by inflation for the rest of your life. You don’t need to worry about the stock markets as there is no ‘pot’ to invest. You just need to hope that the company providing you with the pension stays in business!
But if you don’t have a final salary pension or if the pension doesn’t cover your spending requirements in retirement then hopefully you have built up your own personal pensions and investments.
If you have your own pension pot and you decide you are going to use drawdown rather than purchase an annuity, you will remain in control of the pot and will need to decide the best investments and pension withdrawal rate to ensure it lasts your lifetime.
Starting to withdraw from the pensions and investments you have worked hard to build up is a scary prospect. It feels horrible to think that no more money is going to be added to the pile, you’re only going to be taking away from it.
But when it comes to deciding your pension withdrawal rate, you need to focus on the things you CAN control and be aware of the things you CAN’T.
Pension withdrawal rate factors you CAN’T control
Firstly let’s look at the things you CAN’T control.
#1 – Longevity
You will never know how long you are going to live and therefore you don’t know how long your pensions and investments need to last.
You can check what your life expectancy could be by using the Office for National Statistics life expectancy calculator but at the end of the day it’s a big unknown. Cures are being found for diseases all the time and technology is massively improving our life expectancy year by year.
When I forecast my clients’ financial plans I always show them the position to at least age 100.
#2 – Inflation
The cost of living increases over time.
The average price of a loaf of bread 30 years ago was 37p, today it’s £1.05. That’s a 184% rise.
Imagine your weekly food shop increasing in price by 184% in 30 years time. We don’t know how quickly this increase in prices will happen but we do know the pension withdrawal rate will need to increase to keep up with it.
#3 – Investment returns
Over the long term (20+ years) we can be pretty confident that the great companies of the world (and therefore stock markets) will increase in value. This is capitalism at work.
What we can never be sure of, is the short-term variations in stock market prices.
There will always be nasty falls in the stock markets and if you are withdrawing from your pensions and investments during a fall this will have a massive impact on the future of your pot.
Let’s look at an example:
If your pension falls in value by 20% during a stock market crash and you then decide to withdraw 4% for your spending, the pension will need to grow just over 30% to get back to where you were before the crash. If poor stock market returns continue for a few years and your pension withdrawal rate stays at the same level, your funds will be seriously depleted.
Pension withdrawal rate factors you CAN control
But it’s not all doom and gloom. Let’s look at what you CAN control
#1 – Your spending
During years where the performance of your pensions and investments is poor, you should consider changing your spending habits temporarily and therefore don’t withdraw as much from your pot.
For example, if you were planning on a big holiday, perhaps delay it for a year until the stock markets recover.
Hold off passing any wealth to family until you know you have far more than you ever need to survive.
This is a major topic I discuss with my clients during annual reviews. Drawdown is an ongoing plan that needs checking and adapting every year depending on what has been going on.
#2 – Your investment strategy
Whilst we can’t predict what the stock markets are going to do in the short-term, we can be fairly confident of what they are going to do in the long-term.
This means we can build an investment strategy that is appropriate for the level of risk you want, need and can afford to take.
#3 – Your behaviour
The wrong investment strategy can have a major impact on how long your money can last but your behaviour can have an even bigger impact.
Choosing to sell investments when stock markets have performed badly or buying when they have performed well could seriously damage your future wealth prospects.
You need to have a plan that you stick to, only re-adjusting as circumstances change.
There is no one-size-fits-all strategy when it comes to choosing a pension withdrawal rate in retirement, everyone’s situation is unique and therefore it’s important that you have a plan that is unique to you.
Focus on the things you can control and be aware of the things you can’t.
QUESTION: What scares you the most about withdrawing from your pensions and investments?
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.