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How much can you safely withdraw from a pension? The “4% Rule” is a common principle financial planners use to determine a sustainable withdrawal rate. However, the rule is often misunderstood and may not always suit every client’s case.
Below, we explain how the 4% Rule works and show how it can be integrated into a wider retirement strategy. We hope these insights are useful. If you want to discuss your financial plan with a member of our team, please get in touch to arrange a no-obligation financial consultation, at our expense:
+34 966 460 407
info@scottsdale.eu
What is the 4% Rule?
Many people have two primary goals for their pension in retirement: 1. Make it provide a comfortable income, and 2. Make it last as long as possible.
However, the two goals are naturally in tension. After all, the more income you take from a pension, the faster it could deplete. Conversely, preserving too much capital might not provide sufficient income to cover your retirement expenses.
The 4% Rule was designed to provide a clear “middle way” through this tension – i.e. an individual should be able to draw 4% from their pension(s) each year without running a serious risk of depleting their funds.
For instance, someone with £500,000 in his pension could withdraw £20,000 to cover 12 months of costs in retirement. If the investments grow by 4% or more in the same period, then little/no depletion occurs. As such, the client could draw a decent income whilst ensuring a strong level of pension sustainability.
Issues with the 4% Rule
Many people find the 4% Rule appealing because it is simple, clear and easy to understand. However, a deeper study shows that it might not always work. The timing of an individual’s retirement could be crucial in determining how the 4% Rule affects wealth.
One research paper ran two scenarios for two UK investors. Both followed the 4% Rule, with 50% invested in UK equities and 50% in gilts. The main difference was that Person A began drawing from their pension in 1993. Person B started in 1998.
Person A enjoyed strong investment performance, with their capital gaining 46% in real value by 2008. However, Person B was much less fortunate – suffering a 30-41% loss. This person was disproportionately hit by crises such as the Dot Com bubble and the Global Financial Crash.
This suggests that the 4% Rule alone may not be sufficient to enjoy a comfortable and sustainable retirement income. Two additional elements are required – diversification and adaptation. Let us examine those more closely, below.
Building upon the 4% Rule
The above research played out scenarios using a fairly “basic” investment strategy. However, by spreading out capital across a broader range of asset classes, retirees can enhance their wealth preservation. Moreover, diversifying globally (not just concentrating on an investor’s domestic market) can assist with this. A financial adviser can guide you through the process.
Adaptation – or flexibility – is also important. A blind and consistent 4% withdrawal rate could lead to volatile outcomes. Indeed, a lower or higher withdrawal rate may be more appropriate during certain times depending on factors such as interest rates, your age and the current value of your pension pot relative to future spending requirements.
Try to encourage a “frugal” mindset. This does not mean cutting back on all discretionary (or luxury) spending. Rather, it means evaluating your current spending and cutting back on areas which will not undermine your quality of life. Over time, this could result in continued enjoyment and more savings – potentially reducing the need to reduce your withdrawal rate later (e.g. during a market crash).
Consider using spreadsheets, budgeting apps and other “expense tracking tools” to identify inefficiencies and make adjustments. For those in retirement, regular reviews with a financial adviser can help you monitor and adjust your portfolio strategy and/or withdrawals where necessary. A professional can help you navigate volatile markets, inflation, or other concerns that may be on your mind.
The bigger picture
Remember, pensions come in many forms. Since the 2015 Pension Freedoms, British citizens with UK-based pensions have enjoyed more options for using pensions for retirement planning. There is also the State Pension to consider. These factors bear upon the 4% Rule and its potential use in each case.
For instance, a client might consider buying an annuity when interest rates are high (potentially allowing for better annuity rates). The annuity income could cover the individual’s essential costs in retirement, with drawdown used to cover more luxury items like dining out. By contrast, another client may decline an annuity purchase – perhaps due to poor rates on offer and/or a desire for more income flexibility from drawdown.
Remember, retirement planning involves multiple steps and components. You need to consider multiple variables, including your own unique goals, financial position, future needs, tax situation and more. A financial adviser can help you work through this and tie everything together.
Invitation
If you are interested in discussing your own financial plan or inheritance tax strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
+34 966 460 407
info@scottsdale.eu