One of the important most important questions for drawdown investors is “how much income should be withdrawn each year”. Take too much income and there is a risk that you will run out of money but take too little and you will have lost out on income you could have spent during your retirement.
An annuity solves this problems problem and academics call this the optimum distribution of income throughout your life. Personally, I prefer the rather dark maxim “live your life to the full, spend all of your money and the last cheque you write should be to the undertaker, and it should bounce”
If you don’t want to withdraw too much or too little you will need to work out what is a sustainable level of income.
There are two parts to the sustainable income equation; sustainable in terms of not running out of money and sustainable by maintaining spending power i.e. keeping up with inflation.
The concept of safe withdrawal rates comes from the US where the 4% rule originated. Research using UK data suggests the safe withdrawal rate is between 2.5% and 3.5% depending on assumptions.
Many people misunderstand the original 4% rule. It is not 4% of the fund value each year. It is 4% of the original fund and this amount increases each year by inflation.
If the income was a fixed percentage of the fund the income wound not be predicable as it would change each year depending on investment growth. This will not be suitable for clients who want a predictable income.
The original research on safe withdrawal rates (SWR) was by was by US financial adviser William Bengen in 1994. He worked out the SWR was 4% of the initial amount invested, assuming the income increased each year by inflation and the fund was invested 50% in equities and 50% in bonds. This became known as the 4% Rule.
In the UK the 4% rule has been revised downwards to between 2.5% and 3.5% depending on assumptions e.g. the equity/bond mix. A 60/40 equity/bond spilt will allow for a higher SWR compared to a 50/50 split, but the former will be higher risk. A SWR of 4% can be considered if the income does not increase each year.
The static approach is where the withdrawal rate is agreed at the outset and continues without major adjustments. For instance, 3% of the original amount which increases with inflation or 4% of the original amount which remains level.
The dynamic or flexible approach is where the income is adjusted each year in line with some simple rules. A good example is a 'cap and collar' arrangement where is there is an upper and lower limit for income adjustments. An interesting variation on this is where income starts higher in the early years and changes throughout the different stages of retirement.
The SWR is a useful rule of thumb but advisers shouldn’t just use this blindly as the income strategy for a particular client should be tailored to their individual circumstances. These include; life expectancy, specific income requirements and their attitude to risk and capacity for loss.
Finally, it is important not to ignore the link between annuities and SWRs. After all an index linked annuity is the only way to guarantee a truly sustainable income in real terms.
Sustainable income should be reviewed regularly taking into account factors such as age, health and investment returns.
Our view is the income from an annuity should be used as a starting point or benchmark for deciding how much income to withdraw. Although it might be tempting to use the level annuity as the benchmark, the income from an inflation linked (or fixed escalation) is a better benchmark for the obvious reason it allows for income increases to offset the effects of inflation.