Revealed: the amount of income pension savers can safely withdraw
The falls highlight the challenges and risks involved for those who choose to draw an income directly from their investments at retirement.
One of the biggest dilemmas is deciding how much income to withdraw each year, while avoiding the nightmare scenario of leaving the retirement cupboard bare.
Is there a 'magic' percentage that can help retirees withdraw a safe amount of income from their pension, such that sufficient capital remains to deliver a similar level of income each year during their retirement?
Safe withdrawal rate
According to analysis by Morningstar, the 'safe withdrawal rate' for UK pension savers is 2.5%. This is based on historical returns, on a portfolio split equally between shares and bonds.
The premise is that over any 30-year period the income payments will always be met, increasing in line with inflation. The overall capital may fall or remain intact, depending on market conditions. But the capital value will last the 30 years.
Morningstar's study is notably more conservative than other academic research that has been carried on the same subject.
William Bengen, a former financial planner, carried out the same calculations two decades ago, but instead used a portfolio of 50% in American shares and 50% in American government bonds. Bengen's research found the safe withdrawal rate was 4%.
But Dan Kemp, co-author of Morningstar's report, says for British retirees a safe withdrawal rate of 4% is unrealistic, for several reasons.
"Most studies on the topic have been conducted for US investors using US data, and it was increasingly dangerous to leave this assumption unchecked, given the greater number of UK retirees who must now familiarise themselves with the concept of safe withdrawal rates in light of the pension freedom rules," Kemp says.
Morningstar also assumed an annual charge of 1% for the hypothetical portfolio - something which Bengen did not include.
Moreover, Kemp adds that for those who choose to remain invested at retirement the current environment is more challenging. In the current climate, with bond yields near historic lows, the natural yield of a portfolio equally split between shares and bonds would fall short of 4%.
"With more retirees expected to select pension drawdown over the purchase of an annuity, estimating a UK-relevant safe withdrawal rate is key to helping those individuals manage their retirement savings," he says.
"In the current environment of low yields and high asset prices, clients and their advisers need to set realistic return expectations. We hope this analysis provides advisers with a framework to use with clients when considering the question of retirement spending.
"The generous investment returns of the last century that supported a comfortable and long-lasting retirement portfolio for previous generations of retirees are no longer with us."
Choosing to draw only the income produced by the pension investments (the natural yield), rather than stripping away capital, helps preserve the pension pot over the longer term.
This article was written for our sister website Money Observer.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Final salary pension
A defined benefit pension scheme is one where the payout is based on contributions made and the length of service of the employee. A typical scheme would offer to pay one-60th (0.0168%) of final salary (the one you’re earning when you finally retire) for each year of contributions to the scheme (even though these years were probably paid at a lower salary). Someone retiring on a final salary of £30,000 who had been a member of the scheme for 25 years would receive a pension of 42% of their final salary (£12,300 a year before tax). Sadly, many companies are winding up their final salary schemes or closing them altogether, meaning pension benefits accrued after a certain date (or those available to new employees) may be on a less generous money purchase basis.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.