The 4% pension rule to retire comfortably

Accessing your hard-earned pension pot when you are ready to retire is a major milestone after years of setting money aside.

But deciding when to start taking money from your pension savings, and how much to withdraw, can influence how long the money lasts - and ultimately the lifestyle you can enjoy during your golden years.

As well as hopefully enjoying the returns from your retirement savings, money still needs to be available for bills and possibly your own long-term care.

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That is especially important as the cost of retirement is rising. Inflation rose to 2.3% in October, and inflation will eat into the real value of your pension pot over the long term.

"It’s well known that most people are starting to plan for their retirement too late in life and do not have enough saved for a comfortable retirement," Brian Byrnes, head of personal finance at Moneybox, tells MoneyWeek.

The latest research from the Pensions and Lifetime Savings Association, a trade body, suggests retirees need an income of £43,100 per year for a "comfortable retirement".

Can the 4% pension rule help you plan your retirement? We explain what it is and how it works.

What is the 4% pension rule?

A popular rule of thumb for pensioners is to take 4% of their fund in the first year of withdrawals, and the same monetary amount (adjusted for the rate of inflation) each year.

For example, if your pension pot is worth £500,000, you could withdraw £20,000 in the first year of your retirement. If inflation is 2% during that year, then in the second year you would withdraw £20,400.

This should ensure that your pension pot will support you through a 30-year retirement, in almost any economic environment. For that reason it is often referred to as the safe withdrawal rate (SWR).

Academics at the American Association of Individual Investors devised the 4% rule in 1998 after researching a sustainable withdrawal rate for a retirement pot that wouldn’t deplete the savings.

It looked at data from 1926 to 1995 and found that a rate of 3-4% is “extremely unlikely to exhaust any portfolio of stocks and bonds".

"As a rule of thumb, the 4% rule is a good place to start when thinking about how much you need to save for retirement," Olly Cheng, director of financial planning at Rathbones Group, tells MoneyWeek. "It is a nice benchmark rate to use, and therefore lets people set a simple target to see if they are on track with their savings."

Can I rely solely on the 4% rule?

It is worth thinking about when to start accessing your pension pot, as market returns will have an influence on the success of the 4% rule.

A study from Morningstar in 2022 argued that 3.3% is the “safe” level of drawdown in order to protect a portfolio’s value over the long term.

However, this was based on the fairly downbeat market conditions at the time. Morningstar’s latest insight on the matter suggests that, with today’s more favourable market conditions, a 4% starting drawdown is once again safe.

Market conditions impact the 4% rule because it is based on the assumption that, over a 30-year period, a balanced portfolio (usually modelled as a 50/50 or 60/40 portfolio) will generate sufficient returns to cover the impact of 4% withdrawals annually.

This is true on average, over a 30-year period. Some years, though, a balanced portfolio will grow at less than 4%, and it may even fall in value.

According to Morningstar, in 2022 the average 50/50 portfolio lost 16% of its value. This is why Morningstar recommended a lower safe withdrawal rate for people retiring that year; withdrawing the full 4% would have further compounded their pension pot’s losses during the bad year, before it had a chance to gain value in any good years.

For that reason, it pays to check the economic outlook carefully, and research the safe withdrawal rate for your first year in retirement before jumping straight in with a 4% withdrawal rate. The good news is that it is only during particularly bad years that 4% isn’t a safe initial drawdown rate, which is why this rule of thumb has, on the whole, stood the rest of time.

When should you retire?

This makes timing your retirement a key decision. Ideally, you’ll retire in a good year for your portfolio. In any given 30-year period there are bound to be some bad years, but you want your pension pot to have registered some gains during the good years before these come around.

While hard to predict in advance it is worth checking the economic outlook when you first start thinking about retiring. If the outlook is bad, and you feel you can still manage a year or two more of work, then it could be worth delaying your retirement and giving your pension pot a better chance of getting off to a good start.

This has the added benefit of fattening it up through your working income beforehand, and reducing the amount of time it will need to last you. All these factors swing the maths in your favour, and increase your chances of enjoying a comfortable retirement.

Of course, it is impossible to know in advance whether next year will be a better or worse year to retire than this one. Plus, there are many reasons why you may not want, or be able, to postpone your retirement for an extra year.

For this reason, John Corbyn, pensions specialist at wealth manager Quilter, suggests making more conservative withdrawals early in your retirement, especially if you do happen to retire during a period of economic downturn.

What else do I need to know about the 4% rule?

Like all rules of thumb, says Corbyn, the 4% concept is based on certain assumptions.

“It needs to be overlaid with someone’s state of health and propensity to spend, which is likely to be higher for younger clients and lower for older clients,” he says.

“Care needs to be taken to ensure the attitude to risk and propensity for loss is also built into these assumptions.

“Depending on your risk tolerance, investment strategy, and the actual returns you get, you might consider a slightly more conservative withdrawal rate."

Corbyn says it is crucial to continuously review and adjust your strategy based on your actual investment returns, spending needs, and the broader economic landscape.

“Ultimately, pensions are a long-term savings vehicle and potentially may need to pay for someone’s income for up to 30-40 years, and care needs to be taken if the fund is accessed early, as short-term gain may lead to long-term pain so getting advice is key,” he adds.

"Often, retirement expenditure isn’t a flat annual amount, with the early years sometimes showing a slightly higher expenditure when people want to travel, before expenditure starts to reduce slightly," says Cheng. "In the final years of their lives many people will then see a further spike in expenditure as care is required."

It’s important to note that this strategy may not work for everyone and is just one of many factors to consider when planning to retire.

Make a retirement plan

What you plan to do with your retirement will also have a huge impact on when you should start accessing your pension pot, so it's a good idea to know what you want to do and the costs of doing it.

“If you have dreams of travelling the world then you might need much more retirement income than if you are content with a quiet life at home,” says Corbyn.

“It's essential to have a realistic projection of your monthly and yearly expenses, including contingencies for unexpected costs.

"Cheng echoes this, saying "there is often a real benefit to undertaking some more detailed cashflow planning and speaking to an advisor".

According to Moneybox data, just 11% of people are confident that they will have a comfortable retirement. There is, therefore, "vital need for retirees to have access to the right drawdown advice", says Byrnes.

Pensions tax

Whatever rule you use, experts say it is always important to consider the tax implications when saving for a pension.

This is because beyond the 25% tax-free lump sum, you will need to pay income tax on withdrawals if you are earning above the tax-free personal allowance.

It may not take much to go above the £12,570 personal allowance, given the full new state pension is currently more than £11,500 a year.

“Tax planning is a crucial aspect of accessing a pension, and those who are thinking for instance of buying an annuity or accessing a pension flexibly by withdrawing taxable amounts should take note if they are earning or taking taxable income from elsewhere, including the state pension,” says Alice Haine, personal finance analyst at the investment platform Bestinvest.

“For someone drawing the full flat-rate state pension at the moment, additional income – whether from work or a private pension - of [just over £1,000] will take them over the personal allowance and into basic-rate tax.

“For those with larger pensions or higher incomes, there will be the potential risk of being taken into the higher or even additional-rate tax brackets, and some savers in drawdown should moderate their pension income to avoid this.”

You could consider opening a self invested personal pension (SIPP) to help your retirement planning.

“A SIPP is a type of pension that gives you greater control over your retirement planning – something investors crave,” says Craig Rickman, pensions expert at investment platform interactive investor.

He adds that “Investment growth within a SIPP escapes capital gains tax (CGT) and you don’t pay tax on dividends, either, aiding your money to grow faster. Given the top rates of CGT on investments and dividend tax are currently 20% and 39.35%, respectively, this can deliver a sizeable boost to your eventual retirement pot, improving your financial security in old age.”