How Much Income Can You Take from Your Pension?

How much of your pension portfolio can you withdraw annually to sustain an income in retirement? Dan Kemp investigates

Emma Wall 11 October, 2017 | 8:05AM
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Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today Morningstar Investment Management's Dan Kemp to talk about safe withdrawal rates.

Hi, Dan.

Dan Kemp: Hello, Emma.

Wall: So, there seems to be this 4% rule in the U.S., which means that you can draw down 4% of your pension pot for life and you'll never run out of money. And it seems to be a bit of an urban legend because it's not technically true, is it?

Kemp: No, it's a lovely idea and we love simplicity. But no, it's not true because your safe withdrawal rate depends on a number of factors. There's not just one number. One is what your life expectancy is going to be and obviously, that's been changing over the last few years. So, even if 4% was right in the past, it may not be right now.

Second is the expected returns. And of course, as asset prices rise, the forward-looking returns fall in most cases and so, that's going to drive down your safe withdrawal rate. And thirdly, what is safe? Do you want to be 90% certain that you can draw that money forever or is 50% fine? So, all those factors play a part and we've got to take them all into account when we think about what a safe withdrawal rate is to try and help advisors help their clients make the right decisions.

Wall: Now, last year you did a very in-depth study, one of the first of its kind, looking at that sort of U.S. concept and bringing it to the U.K. You've now updated that for 2017. What are your findings about safe withdrawal rates for U.K. investors?

Kemp: Well, that's right. We thought it was time for a refresh because there has been a lot going on over the last year or so. Firstly, some pension rules have changed. It looks like retirement dates are getting later and that's important. And then secondly, of course, asset prices have risen dramatically reducing the forward-looking returns.

And so, if we take someone who expects to live for 30 years and has an 80% sort of safety view that they want to make sure their pot will be able to provide them for 80% of the time, then the numbers would come down from a safe withdrawal rate of 3.2% to 2.7%. Now, that may not seem huge. But in the context of only starting at 3.2% is quite a large proportion. Or if we think of it in terms of an average pension pot of £50,000 in the U.K., then that's £250 a year. That's significant.

Wall: And of course, it is that cumulative effect. Looking at those two figures there doesn't sound like much, but if you overdraw every year, year in, year out, it significantly decreases the capital that you have to play with, doesn't it?

Kemp: That's absolutely right. And that's the key danger for retirees. But also, we need to remember that those numbers are based on a static real withdrawal through the life of someone's retirement. In reality, people's spending patterns aren't like that.

We've done lots of work in Morningstar led by David Blanchett in the U.S., who is a fantastic retirement researcher, to show that people's spending patterns change that people typically spend more in the first part of their retirement, and then as they become less active, those spending needs decrease and they tend to increase towards the end of life for an end of life care. So, again, we don't want to be too simplistic and people need to adapt their spending to their lifestyle and also, of course, their lifestyle to the capital they have available.

Wall: I suppose the takeaway there is just be mindful of markets, of your own personal needs and of course, that things can change in the future?

Kemp: That's right. And the paradox is that the higher markets are, the lower the expected returns are in the future and probably, the lower the expected withdrawal. And so, you may feel richer because your portfolio pension pot is larger, but that may not mean that you can draw more in the future.

Wall: Dan, thank you very much.

Kemp: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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