Income Drawdown: The Risks You Will Have To Weigh Up
Decumulation and Safe Withdrawal Rates
There are some incredibly subtle threats when it comes to drawing upon your income in retirement using an income drawdown approach; most people understand the big and well-known risks (which we will cover in a moment) but have little understanding of the more subtle ones which, arguably, are far more real and likely to strike.
We believe a good point to begin with is to look at what has been coined “safe withdrawal rates”; we think the findings from research in the US is exceptionally important for you to know.
In the US, retirees have had virtually unrestricted access to their retirement pots for several years. In trying to create ‘safe’ rates of withdrawal for their clients, a number of American Financial Planners have undertaken research aimed at working out how to implement a sustainable withdrawal strategy in retirement.
This includes the work of William Bengen, a retired financial planner, who ran a number of simulations
of historical market behaviour, based on 75 years of data. He reached the conclusion that a first year withdrawal rate of 4.2% followed by inflation adjusted withdrawals in subsequent years, should be safe. This means that the investor should maintain their income without risk of outliving their money. Other research by Gerstein Fisher and Cooley, Hubbard, and Walz comes to very similar conclusions.
This has led to a broad consensus that a safe withdrawal rate can be considered 4% per year; although this is by no means a certainty of security, merely a conclusion based on historical data in the States. And it generally considers a retirement period to be 30 years. This means it is far from fool proof. More valuable work has been done by Wade Pfau, a Professor of Retirement Income at The American College of Financial Services who extended the view to look at how the numbers would stack up in other countries.
Pfau’s research used 109 years of financial market data for 17 developed market economies, providing guidance as to what a sustainable withdrawal rate would be based on historical returns in each country. On this basis he concluded that the safe withdrawal rate for the UK is 3.77%. If a UK investor is prepared to risk a 10% probability of failure, however, this rate improves to 4.17%. At a 5% withdrawal rate, however, the probability of failure is 27.5%.
The conclusion of this is clear: the risks of getting the withdrawal strategy wrong (the ‘decumulation’) are probably much higher than the average retiree may ever imagine; this places a huge premium on getting the strategy right both at the outset and throughout retirement, as the downside of failure is running out of money…
The Big Risks:
1. Getting scammed
The introduction of pension freedom legislation in 2015 provided completely unrestricted access to the over 55’s to their pension pots; this increased flexibility was considered by most commentators to be a very good thing. However it had the knock-on effect of providing the unscrupulous market operator with an equally enticing opportunity. That of targeting retiring people. These operators can encourage inappropriate withdrawals or suggest fancy investment schemes ‘promising’ unrealistic returns. This risk can be managed by ensuring you only use the services of a UK based, fully regulated firm. Make sure you check out carefully the companies you choose to work with.
AT A 5% WITHDRAWAL RATE THE PROBABILITY OF FAILURE IS 27.5%
2. Spending the pension pot quickly/running out of money
IN THE US THE TYPICAL PENSIONER WOULD RUN OUT OF CASH.
One aspect of the new legislation is that it offered control to the pensioner themselves; they could now access their own pension pot with complete freedom to withdraw whatever they wanted, whenever they wanted. This does open up the distinct possibility that an undisciplined or naïve investor could misjudge their position and withdraw large sums (for example to pay for the holiday of a lifetime, a new car, house renovations) and deplete their pension at an alarming rate leaving insufficient behind to provide for income, both now and in the future. The 96-page Social Market Foundation report, “Golden Years? What Freedom and Choice Will Mean for UK Pensioners”, compared what Australian and US pensioners did with their pensions and found that 25 per cent of Australian pensioners exhausted their pots by age 70, and 40 per cent had run out of cash aged 75. In the US, pensioners were depleting their wealth by 8 per cent of their pension pot each year, meaning the typical pensioner would run out of cash 17 years into retirement. To manage this risk efficiently make sure you run a lifetime cash flow simulation and also that you have high regard for the SWR of income – and invest accordingly.
3. Rapid/big investment losses
One of the biggest problems could be that some investors fail to grasp the difference between investing to save for their retirement years and investing in those same years, when they get there. It is an irony that financial advisers have been banging a drum for a long period to encourage or educate people that returns are based on a long game; to be successful at investing you need to ride out the poor years and stick with your growth investments for the longer term. However this same strategy probably will not work for most in their retirement once they are making withdrawals, indeed this would, in all likelihood, prove disastrous. You cannot target a growth rate of say, 6.5% per year, taking 5% withdrawals, without realising that the risks involved are astronomical. The reason why is simple: the risk, with this sort of approach, can be untenable.
If you invest to cover a 5% per year income and you factor in 1.5% per year in costs – then you need to get 6.5% per year return for your pot value to ‘stand still’. However to target 6.5% per year you need to invest relatively aggressively, in risky assets. The impact of a poor year, say a 10% downturn in the value of those assets, would entail a 16.5% reduction in pot value (10% investment loss + 5% withdrawal + 1.5% costs); two years of such losses and your pot value in now already a third less. A saver (who is not taking withdrawals) in a similar position has seen a pot value reduction of about a quarter – and has more time and more flexibility to make this back up than the retiree who needs continuing income.
IMPLEMENT A STRATEGY TO RESPECT AND MANAGE [RISKS].
The Subtle Risks:
Each of these are a variation on the same theme, but have different aspects to them, they are all based on studying simulated returns.
1. Slow and gradual losses
Losses of any sort in a drawdown situation are damaging, but the gradual and long drawn out yearafter-year
losses can be unrecoverable. Although retirement may last a long time (many decades) the pattern of slow losses normally shows highly detrimental effects on pot values.
2. Poor early year returns
The early years of a drawdown are especially important to the success of the income withdrawal/pot value outcome and how long a pot will last. If losses occur earlier, rather than later, in the period it has a proportionately higher impact.
3. Sequential losses
You could have a 20 year period you are looking at where 15 years are positive returns and 5 years negative returns, but if these five years are all in one period (as opposed to being scattered throughout) then the impact is, again, more pronounced.
All of the risks covered can be managed to an extent. The important factor is to (a) be aware of them (b) get cash flow or other future projections of your income/expenditure patterns and possibilities undertaken and (c) implement a strategy to respect these risks and manage them. Managing the risks may include such things as regular reviews and rebalances, blending the use of different products to produce your income, having a high cash balance to support your income in ‘poor’ investment years (so, for example you can temporarily switch off your income to reduce pot depletion) and many more such tactical approaches.
There is possibly no area of financial planning where obtaining the right professional help is more important. Retirement is usually a permanent state, few people retire then decide to, or want to, return to
work. The emphasis on avoiding financial mistakes is of paramount importance. Whereas earlier in life such errors can be overcome and recovered, in retirement they can be unrecoverable. There are many aspects to income drawdown that can represent a risk and can make it complex; there are many different ways any individual can use drawdown and how it is arranged will vary from case to case. All of which stresses the importance of professional help, from an appropriate expert.
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Getting Help And Support for Income Drawdowns
We are able to support you in deciding:
- Is drawdown right for me?
- If so, do I allocate all my pension money into drawdown?
- How much income can I afford to take?
- How do I organise this most tax efficiently?
- Where should I invest the pot?
- Which pension provider should I use to run my drawdown?
- How do I manage my risks?
Interface Financial Planning started providing independent financial advice in 1992. From the beginning it had the aim of providing professional advice and quality service to people with modest income and wealth. Its key value was putting people before profit, and contribution before reward. This mission statement has been our torch to light the path ahead and has been the reason that we have endured for over 24 years. Contact us.
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