Is the 4% safe withdrawal rate still valid for UK retirees - part 2?
Updated: 14 hours ago
In part one of this retirement planning series (we recommend starting there if you haven't already read it), we looked at Bill Bengen's research and four 'challenges' specifically related to data issues you might want to consider when evaluating the '4% rule'. In this post, we continue to address these potential challenges; this time, we look at those related to the 'real world'.
Challenge Five: Zero fees
Bill Bengen's research did not make an allowance for investing costs. There are many costs a retiree needs to consider, and 'How much does a financial adviser cost for retirement planning (and am I getting good value)?' looks at these in more detail, including the following:
Discretionary fund manager fees
Financial adviser fees
Recall from the previous article that for a 50% stock portfolio with zero costs, the historical safe withdrawal rate (SWR) was 3.37%, with the money running out after around 22 years (eight years short of a 30-year retirement horizon). If we apply a 1% per annum (pa) total cost, the SWR has fallen to 2.99%.
Note that this is less than the 1% reduction we might expect. In poor scenarios (i.e. the ones that tend to produce the worst-case historical SWRs), the costs tend to drop along with the portfolio value (assuming the fees are charged on a percentage of the invested assets basis). In contrast, inflation-adjusted withdrawals tend to increase over time, meaning that in these poor scenarios, the costs are relatively small versus the withdrawals and hence have a smaller impact than might be expected.
In the worst case, the portfolio is now exhausted after around 18 years, a reduction of four years.
Total costs for those using a financial adviser are estimated to be between 1.9% and 2.3% per annum. If we increase the total costs to 2.5% pa (these levels of costs are unfortunately more common than you might expect/hope), the SWR has reduced to 2.47%.
In the worst case, the portfolio is now exhausted after 15 years.
Challenge Six: 30-year retirement horizon
Bengen's research looked at portfolio sustainability for a minimum 30-year retirement, which we have used for challenges one to five. Timeline can incorporate the Office of National Statistics (ONS) survival rates, and we can use this option to forecast when either David or Samantha has a survival probability of 10% or less. For David and Samantha, at their retirement ages of 60 and 55, respectively, this would be when Samantha is 100. This increases the retirement horizon from 30 to 45 years.
The impact of the retirement pot having to last for an extra 15 years reduces the SWR from 3.37% (from Challenge One) to 2.91%.
You can see that in the worst case, the pot runs out a long way before Samantha's 100th birthday, and this scenario assumes zero fees!
Challenge Seven: Not evaluating whether the money is likely to outlast the retiree
We have so far looked at fixed 30 and 45-year retirement horizons. In the real world, we care about whether or not we outlast our money. We have two variables to consider:
The chance of a retiree's portfolio running out at a given point in time.
The chance of the retiree being alive at this point.
If we look at the 45-year horizon we used in challenge six, the diagram below shows that:
1. The chance of David or Samantha being alive at the end of Samantha's 99th year is 10% (as covered in challenge six).
2. The chance of the portfolio making it this far is 93%.
The chance of David and Samantha being alive at this age and the portfolio running out is, therefore, less than 1%.
(10% chance of them being alive multiplied by 7% portfolio failure rate = 0.7%)
Challenge Eight: Not adjusting spending throughout retirement as remaining life expectancy changes
As described above, at the outset, David and Samantha would have to adjust their SWR downwards from 3.37% to 2.91% if they wanted to extend their retirement horizon from 30 to 45 years. But that is just at the beginning of their retirement. How would things look if they were 15 years older (David would now be 75 and Samantha 70) and both in good health? Assuming that inflation and market returns had been reasonable, could they not consider increasing their spending at a faster rate than the initial inflation-adjusted 2.91%? Our original thirty-year horizon had the SWR at 3.37%, and at Samantha's age of 70, they may want to plan for 30 years remaining (which might make our original 30-year 3.37% SWR more appropriate).
It's worth mentioning that as people get older, their life expectancy (which is different from their remaining life expectancy) increases. For example, in the UK, the life expectancy of a 65 year old male is 85 (20 years remaining life expectancy), according to the ONS.
For a 75 year old man, this increases to 87 (12 years remaining life expectancy). This is because there was a non-zero chance of them dying between the ages of 65 and 75, and the fact they didn't means their life expectancy increased (although their remaining life expectancy will, of course, reduce).
Challenge Nine: Spending is assumed to increase with inflation each year
Bengen's logic assumed that David and Samantha increased their spending in line with inflation each year. In the real world, spending doesn't necessarily follow this pattern, with spending tending to grow at less than inflation.
The International Longevity Centre UK (ILC) concluded that "A household headed by someone aged 80 and over spends, on average, 43% (or £131) less than a household headed by a 50-year-old.
If we modify David's and Samantha's spending to increase by 1% less than inflation each year, the starting SWR increases from 3.37% to 3.58%.
Challenge Ten: Does not allow for spending flexibility
Bengen's annual inflation-adjusted withdrawals method does not cater for spending flexibility. For example, say that David and Samantha want to spend an extra £20,000 five years after retirement to take the family (including their three children and partners) on holiday to celebrate Samantha's 60th. This would be tricky to incorporate into the existing methodology. Would they take the £20,000 and spend £5,000 less over the following four years? The rigid logic does not cater for these real-world spending patterns.
Challenge Eleven: Other income sources are not taken into account
One of the assumptions we made for David and Samantha was that they had no other sources of income. The reality is that most people in the UK will receive some form of state pension. 2019 research suggests that most get at least 75% of the full state pension, which is broadly our experience when dealing with our clients. With the full state pension now over £10,000, a couple with full state pensions could see their gross income increase by over £20,000 per year when they reach their late 60s.
If we add two full state pensions for David and Samantha, we can see that they can now spend over £50,000 per year vs the original £33,700.
Challenge Twelve: Dying with too much money
So far, we have looked at worst-case outcomes, which determine the historical SWR. The reality is that there is a vast range of retirement outcomes. Let's revisit challenge one in the previous article, with an SWR of 3.37%. We can see that if David and Samantha start with a 4% withdrawal (£40,000) and increase with inflation each year, the average scenario (blue line) has the investment pot being larger in inflation-adjusted terms (around £1.2 million) at the end of the 30 years than when they started.
Indeed, in the best case, the investment pot is over six times larger in real terms after thirty years than at the outset.
Put another way, if David and Samantha had retired in 1981, they would have been able to have a starting withdrawal of 11.1%, which is over three times (3.37%) had they started in 1915.
It's worth noting that the median outcome allows us to take a 6% inflation-adjusted withdrawal with the money (just!) lasting the entire 30 years.
Using a fixed withdrawal rate can have you dying with too much money, which some might feel is almost as bad as running out of money. The Timeline extract below shows the balances for every one of David and Samantha's retirement years when withdrawing an inflation-adjusted £40,000 per annum.
Our challenge is that we don't know what outcome we will likely experience. David and Samantha may get lucky, or they may not. Luck, in this case, tends to mean a good first decade. This is frustrating for us retirement planners; as you can see from Challenge Nine, spending tends to be highest in early retirement, and we want to encourage our clients to spend their money while they (hopefully) have good health. Unfortunately, at this point, we don't yet know how the first decade will pan out in terms of portfolio returns and inflation and whether we may have a favourable tailwind or a painful headwind!
Challenge Thirteen: Not adjusting spending depending on how "lucky" your retirement outcome is
Following on from challenge twelve, the fixed annual inflation-adjusted withdrawal approach does not allow for flexibility of retirement spending if our early retirement years turn out to be reasonably favourable (or at least not disastrous).
For example, if we take our best case (1981 retirement), after the first (pivotal) decade, David and Samantha's portfolio balance has approximately doubled in real terms. Given this favourable tailwind, they may feel justified in increasing their spending over inflation. Bengen's rigid logic does not allow for this.
This article focused on real-world challenges and how they impact the retirement plan. In part three, we look at investor challenges.
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