What is a safe amount to take from a pension?
Nearly half of those withdrawing money from pensions may be doing so at an unsustainable rate, according to analysis of industry figures by Schroders.
It once again raises the difficult question of how individuals can calculate a safe level of income withdrawal that will ensure their pension pot outlasts them.
The Association of British Insurers (ABI) has published data on the first full year of “pension freedoms” for the UK, shedding some light on rates of withdrawal for those who enter drawdown. It said “a minority may be withdrawing too much too soon and at rates that would see their money run out in a decade or less, if they are reliant on their pension pot as their main source of income”.
The ABI, which represents the majority of pension providers, said 3,379 pots – or 4% of the total – had more than 10% of the money withdrawn in the first three months of the year. Withdrawing from a pension pot at that rate would involve taking out 40% a year, meaning that it would be wiped out in two and a half years.
The ABI said most savers were “taking a sensible approach” with 57% pots seeing only 1% of their value withdrawn in the quarter, equivalent to 4% a year. They also said that they did not know whether those who were withdrawing at higher rates had other income to fall back on.
The table below shows the number of pension pots drawing different amounts.
Yvonne Braun, the ABI's Director of Policy, Long Term Savings and Protection, commenting particularly on those who were taking out larger amounts, said: "There may well be other factors at play here, such as people having other retirement income, for instance, final salary pensions or multiple pots. But this is a warning sign that requires further investigation.”
What are “pension freedoms”?
Prior to April 2015, some savers were forced to buy an annuity, to provide fixed income for their retirement. Since then, savers have had far more options. They can withdraw money at will or keep it invested to generate income that can be paid regularly. Tax implications may have an impact on such choices.
Savers over 55 can take 25% of their pension pot tax-free. Some do this as a lump sum but it can be spread over several years. That can also help manage tax liabilities because the other 75% is subject to an individual’s marginal income tax rate for that year.
To take money regularly to provide an income, savers enter “drawdown”. The ABI figures show 90,700 savers have opted for this, keeping an average of £67,500 invested.
What is a safe level of income to take from a pension?
This has become one of the most hotly debated questions in financial planning, and not only in the UK. Many countries have income drawdown options including Australia, Canada, New Zealand and Ireland.
The ABI is concerned that savers taking more than 10% in just three months, assuming no other sources of income, is far too high. At this rate, a £100,000 pot would be reduced to £60,000 after a year and would be gone in two and half years, or maybe a month or two longer if a little investment growth is included.
Even the more moderate scenarios in the data may cause concern with one in five pots seeing withdrawal rates of 4% to 8%, if the figures are annualised.
A £75,000 pension paying income of £500 a month, which is £6,000 a year or a withdrawal rate of 8%, would be exhausted in 13 years and eight months. This is based on the calculations of the UK’s government-backed Money Advice Service (go to moneyadviceservice.org.uk/retirement-income-options). It assumes 5% investment growth, annual charges of 1.25% and increasing the income in line with inflation.
Perhaps the biggest difficulty in managing your own retirement money is guessing how long you will live and what investment returns you might expect. An independent financial adviser can help with this.
Sheila Nicoll, Head of Public Policy at Schroders, said: “It is important for people to use the guidance available, and to take independent advice.
“Most importantly, most people should not underestimate how much money they may need – some people may live more than thirty years after retirement – so what sounds like a large lump sum doesn’t sound quite so large when spread across that kind of period.”
The ‘4% rule’… or the ‘3.2% rule’
Analysts the world over have theorised on safe withdrawal rates long before the introduction of pension freedoms in the UK.
Investment returns affect how much can be taken from a pension. While history does not provide guidance for future returns, it offers food for thought.
A rule of thumb in the US has been that 4% was the optimal amount to withdraw from a pension – starting at a withdrawal rate of £4,000 from a £100,000 pot and rising with inflation. Taking any more runs the risk of the pot dwindling and running dry within 30 years, so the “4% rule” goes.
Research conducted by Morningstar, an investment analysis firm, earlier this year challenged this assertion, at least for countries outside the US, which had seen periods of lower investment returns.
It looked at historic safe rates of withdrawal for different countries. It found that in the US, the figure was as high as 10% in the 1980s, when stock markets boomed.
It found the safe rates of withdrawal were broadly similar for the UK but also found periods when these rates were very low safe - around 2.5% - in the first decade of the 20th century and in the late 1930s and early 1970s, when investment returns were particularly low. The rate had never fallen below 4% in the US.
It concluded, retrospectively, that the UK should have had a “2.5% rule”. Many other countries were found to have had even lower safe rates of withdrawal: less than 2% in Spain and below 1% in France, Italy, Belgium and Germany.
Morningstar also attempted to project future scenarios. Based on long-term average returns for today’s market valuations and having a balanced portfolio, it suggested 3.2% might be the highest amount that could be safely drawn each year. The researchers assumed investors’ portfolios were mostly invested in domestic assets.
Based on the 3.2% withdrawal rate, if a retiree wanted retirement income of £10,000 a year, increasing with inflation, they would need to start with £312,500, it was suggested.
How quickly could £100,000 disappear?
An alternative study, conducted by Cazalet Consulting in 2014, calculated what would happen to £100,000 invested in the FTSE All-Share in 2000 with different levels of income taken each year.
Withdrawal starting at £5,000, and rising by 2.5% a year, saw the pot decline to just under £40,000 by 2013, or less than £20,000 if starting at £6,000 a year. At higher withdrawal rates, the money would have dried up within the 13 years: a rate of £8,000 a year would see the pot evaporate by 2010 or by 2018 if £10,000 had been the start rate.
It should be noted that the performance of the FTSE All-Share was particularly poor over the period, even with dividends included, and financial advisers would more likely recommend a mix of assets. But the statistics still make a point. Read more here.
For some retirees unclear about how long they might live, the aim will be to preserve all their capital. This has become more desirable given pension pots are now offered protection from inheritance tax.
For this reason, some may wish to only draw the income generated by a portfolio. Finding decent income has, of course, become harder as interest rates around the world have fallen.
“Taking anything more than the natural rate of income thrown off by a portfolio potentially reduces the real value year on year – anyone taking too much early on is exacerbating the issue,” said Robin Stoakley, Managing Director of UK Intermediary at Schroders.
“The UK stock market yields around 3.5% today. It can be tempting to take too much too soon but retirees need to think long-term. They need to manage their portfolio as a farmer manages a field – overwork it today and it will yield a worse crop in the years that follow.”
Making a pension last a lifetime is complex. Regular input from an independent financial adviser can you help make better choices.
Andrew Oxlade is the former head of personal finance for the Daily and Sunday Telegraph
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