Is the 4% safe withdrawal rate still valid for UK retirees?
Updated: Dec 6, 2021
Retirement planning can be a challenging task. The unknowns of longevity, investment returns and inflation make it challenging to construct a robust retirement plan that gives you the confidence to enjoy your desired lifestyle without fear of running out of money.
A standard 'rule of thumb' is that you can safely take an inflation-adjusted 4% out of your investments each year without running out of money. This blog investigates how relevant this rule might be to a UK retiree and whether current market conditions means the rule is no longer valid.
In 1994 William “Bill” Bengen published a landmark paper in the Journal of Financial Planning named 'Determining withdrawal rates using historical data'. As the title suggests, Bill analysed historical market data and determined the highest withdrawal rate, as a percentage of the initial investment pot that an investor could withdraw each year, and adjusted for inflation in subsequent years without running out of money over a thirty-year retirement. An example is shown below:
Starting pot: £1,000,000
Withdrawal in year one: £40,000
Inflation at the start of year two: 2%
Withdrawal in year two: £40,800 (£40,000 * 1.02)
Inflation at the start of year three: 3%
Withdrawal in year three: £42,024 (£40,800*1.03)
Repeat every year.
Bengen named this the Safe Withdrawal Rate (SWR) and found that the SWR was around 4% for his dataset. It's worth noting that Bengen never claimed that the SWR was a rule, something he believed was invented by the media, according to an interview with Michael Kitces conducted in 2020.
Flaws with the 4% rule
There are several potential issues with relying on the '4% rule' when planning your retirement income strategy. To better illustrate, we shall use a fictitious couple, David and Samantha Smith. David is 60 and has recently retired from ABC Chemicals. His wife Samantha is 55 and is also retired. Together they have a retirement portfolio of £1,000,000 and are looking for a sustainable income of £40,000 per annum. David has read various articles on the '4% rule' and believe they will be OK based on this.
Flaw One: US data
Bengen used US historical data for his work, with a split of 50% US equities (shares) and 50% US bonds. Let’s look at how a UK investor would’ve fared. To test this, we will be using a software tool called Timeline, used by an increasing number of financial planners, particularly those specialising in retirement planning. It uses historical market returns across broad asset classes and inflation data to provide a range of outcomes. For example, had (older versions) of David and Samantha retired in September 1962, Timeline shows whether they would have run out of money, given their planned portfolio and withdrawals. However, by retiring a month later, the outcome would have been slightly different. By analysing hundreds of such historical outcomes (twelve per year for over a hundred years), we can obtain a valuable insight into the future potential outcomes which David and Samantha might reasonably expect.
We will use a portfolio consisting of 50% global* equities and 50% global bonds, historical UK inflation and a 30-year retirement horizon (i.e. David dies at 90 and Samantha at 85).
As can be seen from the screenshot below, the news is less favourable for UK retirees compared to their US equivalents, with David and Samantha only able to take out a maximum initial starting withdrawal of £33,000 (3.3%) in the first year without risk of running out of money further down the road.
The worst historical period for the Smiths to have started their withdrawals would have been December of 1968, where the double whammy of persistently high inflation and falling markets in the 1970s would have placed their retirement pot under strain.
Flaw Two: 30-year retirement horizon
The original research was primarily structured around a 30-year retirement, which was used for David and Samantha’s example above. Timeline has the option to incorporate the Office of National Statistics (ONS) survival rates, and this forecasts that when either David or Samantha have a survival probability of 10% or less, Samantha would be 99 years old. Given her current age, this increases the length the retirement pot has to last from 30 to 44 years.
The impact of the retirement pot having to last for an extra 14 years reduces the SWR from 3.3% to 2.92%.
Flaw Three: Zero fees/perfect investor behaviour
In the real world, we have to consider the impact of fees and investor behaviour that can have a drag on our investment returns, and therefore portfolio sustainability:
Fees: These can include financial adviser, platform, funds and discretionary fund manager (DFM) fees. Total costs for those using a financial adviser are estimated to be between 1.9% and 2.3% per annum. 'How much does a financial adviser cost for retirement planning (and am I getting good value)?' looks at financial adviser fees in more detail.
Investor behaviour: Studies continue to show that investors underperform the very funds they are invested in - a recent Morningstar report being one example. A real-world example of this behaviour was investors in the Magellan fund when Peter Lynch ran it. During Lynch’s tenure, the fund returned an annualised 29%, yet the average investor made only 7% per annum during the same period, according to research from Spencer Jakab. This underperformance may have been down to investors buying when the fund was doing well and selling when underperforming (effectively buying high and selling low).
For our example, we will concentrate on just fees, using 1% total costs, which are typical for Pyrford Financial Planning clients with £1m invested.
The SWR has fallen by just over 0.5%, from 2.98% to 2.47%. Intuitively, one might expect the SWR to fall by more or less the amount of fees, but research by the Timeline team show this is not the case.
Taken to the extreme, annual fees of 2.5% reduce the SWR to 1.86%.
Flaw Four: Spending is assumed to be unchanged in retirement
Bengen's analysis assumed expenditure increases in line with inflation throughout retirement. However, the reality is unlikely to follow this simple assumption. Research from the International Longevity Centre (UK) shows expenditure typically reduces from early retirement (when we hopefully still have good health and our brains are still sharp) into late retirement.
In addition, big-ticket items (such as the round the world trip you’ve always promised yourself) and provision for later life care might need to be included in a 'real-life' plan.
Flaw Five: Asset allocation of 50% equities and bonds
As a general rule, increasing the equity content of a portfolio tends to increase portfolio sustainability and therefore, the SWR. For example, increasing equity content from 50% to 60% in our example portfolio raises the SWR from 2.47% (1% fees from flaw three) to 2.6%.
Conversely, reducing the equity content to 40% reduces the SWR to 2.28%.
Flaw Six: Limited historical data
There have been concerns that in the current environment of low bond yields and inflated equity valuations, the 4% rule no longer applies. Putting aside the five previous flaws above, it’s worth bearing in mind the turbulent historical markets gave us the SWR. That said, we only have historical data going back around a century, and there is nothing to say that we won’t experience a worse period over the next century than we've had over the last one.
*'Global in these examples meaning Developed Markets only.
We have covered some potential downfalls of relying on the '4% rule', with some key takeaways below:
The UK has its own set of unique circumstances, meaning that data from other countries is unlikely to be relevant.
Several factors can reduce the perfect SWR dramatically in some cases. For example, a couple in good health that had retired in their early 50s that were paying ~2.5% per annum in ongoing fees and holding a retirement portfolio with a relatively modest equity allocation may be surprised by how low their SWR could be.
Want to find out more
If you would like to find out more about creating a robust retirement plan, including establishing a sustainable retirement income, please schedule a free, no-obligation call.
Noel Watson and the team at Pyrford Financial Planning are Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide pension advice, investment advice and inheritance tax advice.
Our office telephone number is 01932 645150.
Our office address is Wellington Way, Weybridge, Surrey, KT13 0TT
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Although best efforts are made to ensure all information is accurate, you should not rely on this blog for your personal situation or planning.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.