When you hit retirement you are going to need sustainable pension withdrawals.
If your pension withdrawals are not sustainable it is going to mean a very difficult retirement. You may have to move home, go back to work or worst, not do the things you love and enjoy.
Knowing what level of sustainable pension withdrawals are right for you will allow you to know how much savings and investments you need to retire.
What are sustainable pension withdrawals?
Sustainable pension withdrawals are the amount of regular payments you can take out of your pension that mean it will never drop below zero. Basically you die before the pension pot dies!
For some people they are happy that their pension pot runs down to zero at the point they die and for others it is important that they leave something behind for their loved ones.
One easy way to ensure sustainable pension withdrawals is to convert your pension into an annuity. A pension annuity will pay you a pension income at a level you set (based on your pension value) until you die, and then some for your spouse (if you select this option).
However the problem with pension annuities is that they are not flexible. You will have to choose the type of income you want at the start (depending on the size of your pension pot) and that’s it. Forever. No higher spending while you’re younger and healthier. No option to make lifetime gifts.
So to get the flexibility you need to use pension drawdown, taking as much out as and when you want to. But the more you take and the earlier you take it, the more chance your pension pot runs out.
One popular theory for sustainable pension withdrawals is ‘the 4% rule’. There is some evidence to suggest that if you only withdraw 4% of the value of your pension pot each year, your pension pot shouldn’t really fall in value.
The problem with the 4% rule is the same as it is for annuities. There is no flexibility if you want a higher income in certain years or larger one off withdrawals on an ad-hoc basis.
There is no one right level when it comes to making sustainable pension withdrawals. Everyone’s needs are different so it is important you find out your own level.
The process for determining sustainable pension withdrawals for you
In order to determine what pension withdrawals are sustainable you need do 5 things.
#1 – Develop a retirement spending strategy
How much do you need to cover your essential bills? How much time will you spend travelling and eating out etc? How often will you replace your car?
You will find that there is a base line expenditure amount that you spend every month, every year and then some years where your spending is higher depending on your one-offs.
If you find thinking about your future spending difficult then start with what you spend now, as in my experience most people don’t want to change their lifestyle too much.
#2 – Factor in inflation
Having worked out your retirement spending pattern you need to apply inflation to it.
Remember prices generally go up every year. So if you’re planning for a 30 year retirement things are going to cost a lot more in the future.
A rate of between 2% and 4% per annum would be prudent.
#3 – Factor in Tax
It’s likely a large proportion of your pension withdrawals will be taxed so you will in fact need to withdraw more than you think from your pension to cover this.
For example, a basic rate tax payer in retirement who needs £2,000 per month for spending will actually need to withdraw £2,500 per month from their pension.
#4 – Investment strategy
You need to choose an appropriate investment strategy and project an appropriate investment return.
Keeping your pension funds in cash is unlikely to be an option for the majority of people in retirement. Inflation will eat away at your pension pot until there is nothing left. This will happen much quicker than you think.
An appropriate investment strategy will ensure your pension and withdrawals at least keep pace with inflation and hopefully deliver you a return above inflation.
#5 – Test, test and test
If you have done all of the above then you will be in a better position to understand what pension withdrawals are sustainable for you.
However 30 years is a long time in retirement and if your assumptions are wrong then it could have drastic implications for your pension pot. You may not see this disaster coming until it’s too late and with little time to adapt.
Remember stock markets and inflation do not go up in a nice straight line. There will be troubling years ahead. The recent pandemic being a good example. These types of events can cause huge falls to pension values.
This is why it’s so important to stress test your pension withdrawals under all scenarios.
We use some great software with our clients that allows you to input your spending plan, setting different levels of withdrawals for different years , including one-off larger spends. We then overlay tens of thousands of different investment and inflation return combinations.
This then produces a result which tells us in how many scenarios you achieved sustainable pension withdrawals. We of course then re-test this every year.
If you would like your retirement plans stress-tested so you know what level of pension withdrawals are sustainable for you then why not take advantage of our free 15-minute call. You can speak to a Chartered Financial Planner who will listen to your situation, give you an outline of what you need to consider and guide you in the right direction.
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.