How much of your pension can you afford to spend each year?

In today's low-interest-rate world, knowing how much pension to draw down can be tricky, says Natalie Stanton.

There's a well-known pensions rule of thumb if you start out your retirement by spending 4% of your pot in the first year, then increase that sum with inflation each year, it's unlikely you'll run out of cash before you die. This so-called "safe withdrawal rate" has been relied upon for years. However, new research suggests that, in today's low-rate world, this advice is out of date, and that retirees should now be more conservative.

So what's wrong with the 4% rule? Investment research group Morningstar points out that the figure is based on research carried out in America in the 1990s, and is therefore not necessarily suitable for use in the UK, particularly in the current environment.

While the historical performance of stock and bond markets in the UK has been relatively similar to the global average, American returns have in fact generally been higher, says Morningstar. "US returns have yielded the highest initial safe withdrawal rates across... 20 countries historically."

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Another, more basic, problem is that the research that first produced the 4% rule failed to take account of fees. These are likely to make a significant dent in your pension fund. Finally, the research was based on a retirement period of 30 years. Now many people are living longer in retirement, so the money may need to last even longer.

In short, "the generous capital-market returns of the prior century that bolstered a comfortable and long-lasting retirement portfolio may give 21st-century retirees a false sense of security", says Morningstar. The firm's recommendation is that UK retirees should withdraw around 2.5% each year (£2,500 from a £100,000 pot).

The new research is highly relevant to the tens of thousands of retirees who are in "drawdown", or who plan to use drawdown when they retire, rather than buying an annuity (which means trading your pension fund for a lifetime income).

Under drawdown, your pension stays invested (and hopefully keeps growing) and you use it to fund your spending each year. This means you don't sacrifice your capital, but unlike an annuity, it doesn't come with any guarantees. If your money runs out before you die, so does your income. Hence the vital importance of making sure you don't take too much too soon.

Natalie joined MoneyWeek in March 2015. Prior to that she worked as a reporter for The Lawyer, and a researcher/writer for legal careers publication the Chambers Student Guide. 

She has an undergraduate degree in Politics with Media from the University of East Anglia, and a Master’s degree in International Conflict Studies from King’s College, London.