Don’t blow your pension

Anybody planning to take advantage of the new pensions rules needs to think carefully. Cris Sholto Heaton explains.

The new pension rules coming in this April will entirely change the way we take our pension funds at retirement. Up until now, most people have used their pension to buy an annuity, giving them a set income for the rest of their life.

For many years there has also been an option to draw an income out of your fund instead (income drawdown). But for most retirees the amount that you can take has been capped at a level similar to what would be available from an annuity.

Only those with a certain level of guaranteed income for example, from other pensions have been able to withdraw as much as they like. However, under the new rules, everybody will be able to take out whatever they want even the whole amount the day after you turn 55 if you want to. The first 25% will be tax-free and the rest will be taxed at your income-tax rate.

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This change has been controversial. Supporters see it as freeing savers to fund their retirement in whatever way best suits them. Critics say that it will leadto people depleting their savings too quickly, ending up in poverty in later life.

While we'd agree that giving people the freedom and responsibility for making their own financial decisions is best, we don't think the risks should be underestimated. Judging how much you can safely take out of your pension is not a simple decision.

Anybody planning to take advantage of the new rules needs to think carefully from the start about how much of their savings they can spend.

Three factors to consider

1. How long you are going to live after retirement

2. What your investment returns will be

3. Whether your cost of living is likely to rise significantly

In addition, our personal cost of living increases will differ. Some retirees may find that their medical and care costs rise in later life, while others will remain in good health.

What this means is that any estimate of how much you can safely spend is subject to a lot of uncertainty.

Buying an annuity does away with much of this: it guarantees you an income for the rest of our life and it shifts the investment risk onto the insurer. As far as cost of living goes, you can get annuities where the income rises in line with inflation each year.

However, this won't address the risk that your personal expenses rise significantly. That can be insured to an extent through products such as long-term care insurance, but these tend to be relatively expensive.

How much should you take out?

So it's understandable that many investors consider them poor value, and will at least consider using drawdown when the new rules come into effect. Given that, what can we say about what a safe withdrawal rate might be?

By far the best-known research into this is a 1994 study* by American financial planner William Bengen.

Based on investment returns data from 1926 to 1992, he calculated the maximum that an investor with a 50/50 portfolio of US large-cap stocks and government bonds could have taken out each year without running out of money before they died (assumed to be 30 years after retirement).

He found that an investor who began by drawing 4% of the initial value of their fund each year and increased that payment inline with inflation each year would always have been safe.

The 4% rule quickly became an accepted approach among retirement planners in the US, where annuities are relatively uncommon. While some have criticised it for being simplistic and showed that more sophisticated tools can give higher withdrawal rates, that simplicity is attractive to people who don't want to engage in complicated modelling.

A time to be conservative

Safe rates varied widely, with especially poor results in countries that saw major wars fought on their territories. However, even in those that enjoyed a more favourable century, rates of 2.5%-3.5% were more typical.

While it's impossible to predict future investment returns, they seem likely to be lower than in the past. So the lower end of these withdrawal rates is a more conservative assumption today.

That's also consistent with current annuity rates: an inflation-linked annuity for a 60-year-old pays around £2,500 for every £100,000 invested. So while you can probably fund a moderately higher income through drawdown, anybody banking on taking out much more will run a significant risk of exhausting their savings too soon.

* Determining withdrawal rates using historical data, William Bengen, Journal of Financial Planning, October 1994

** An international perspective on safe withdrawal rates from retirementsavings: the demise of the 4 percent rule?,Wade Pfau, National Graduate Institute for Policy Studies, September 2010

Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.