How to make your pension last a lifetime

2 November 2017

It’s terrifying to think of running out of money in your later years but it would be devastating to go through retirement scrimping and saving when you could have had a better life.

And these are the two extremes that anyone faces when using the new pension freedoms to take as much or as little as you like from a defined contribution pension once you reach age 55.

It’s great to be able to take a lump sum out of your pension to spend on a special trip abroad or a new conservatory to celebrate your retirement. But then you need to make a plan to withdraw regular income through income drawdown –  the most difficult financial plan that you will ever put in place.

Trying to determine how much income it is reasonable to take is not easy because many factors can affect the value of a pension pot and how long it will last.  These include your life expectancy (often higher than people think) and how the underlying investments in your pension are likely to perform (unpredictable).

In the past many investors have followed the ‘4% income rule’, the amount that retirees can safely withdraw from their pension pots. This was based on research by William Bengen, a former financial planner, who carried out the calculations two decades ago, using a portfolio of 50% in American shares and 50% in American government bonds. His research found the ‘safe withdrawal rate’ was 4%.

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 full 30 years.

However, at the start of 2017, the '4% rule', was described as outdated. Research by pension company Aegon and actuarial firm EValue, found that a 65-year-old entering income drawdown in a low-risk portfolio today and taking 4% each year has a one in five chance of running out of money within 30 years.

Instead, the 'safe withdrawal rate' should range between 1.7% and 3.6%, concludes the report. The exact figure will largely depend on an individual's risk appetite.

The level of the stock market also is a big factor in how much you can withdraw safely from your pension. 

In October, investment analysts at Morningstar, calculated that high prices driven by booming stock markets mean that if you took 4% income from a pension pot (invested 40% in equities, with 60% in bonds) today your money could run out after 20 years.

Morningstar says that if you want to be 99% sure that your money will last 30 years, then the amount you can ‘safely’ withdraw each year from an invested pension drops to just 1.8%. 

This may come as a bit of a shock. But please don’t ignore it. At the time of writing, on 17 October, the FTSE 100 index of the biggest 100 companies listed on the London Stock Exchange had neared an all-time high.

Dan Kemp of Morningstar says: “Most people retiring now will have had 5% interest rates for most of their lives. The pot of money from pension freedoms may seem huge. So people believe that they are richer than they are.”

The Morningstar research factors in a 1% fee on investments, which acts as a drag on returns and illustrates the importance of keeping investment fees low.

Retirees will also have to factor in inflation, which has reached a five-year high of 3% as consumers continue to battle against rising food and transport costs, according to the Office for National Statistics. Inflation is also significantly higher than the Bank of England’s 2% target. This will add to the pressure on the central bank to raise interest rates, which could help in your search for income.

But Vince Smith-Hughes, retirement expert at Prudential, says: “Rising prices will squeeze the incomes of pensioners. Drawing too much income from their pension fund too quickly increases the chance that they prematurely exhaust their funds in retirement. Rising food prices are a particular concern because a higher proportion of pensioners’ income is spent on food.”

If in doubt, consult an independent financial adviser who will be able to advise you on how much income is sensible to take based on your circumstances. Yes, it will cost money, but I think it’s worth paying to have peace of mind. But if they mention the 4% rule, I’d look for another adviser.