Why it isn't safe to take 4% income from your pension
The '4% rule', the amount that retirees can safely withdraw from their pension pots, has been described as outdated.
Most financial advisers stress that a maximum withdrawal rate of 4% is sensible, and that it's preferable for retirees to draw only the income produced by the pension investments (the natural yield) rather than stripping away capital.
The 4% figure, rather than being plucked out of thin air, was based on academic research. 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.
What is a 'safe withdrawal rate'?
William Bengen, a former financial planner, carried out the calculations two decades ago, using a portfolio of 50% in American shares and 50% in American government bonds. Bengen's research found the safe withdrawal rate was 4%.
But research by pension company Aegon and actuarial firm EValue, has found that economic conditions and improvements in life expectancy are casting doubt over the historic rules of thumb designed to help those in drawdown determine a 'sustainable' retirement income level.
Number crunching by the firms found that a 65-year-old entering 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.
Separate research last year by Morningstar put the 'safe withdrawal rate' for UK pension savers at 2.5%.
The reason why the figure is lower is that bond yields are much lower than when Bengen carried out his study in the early 1990s.
A typical balanced portfolio consisting of 50% shares and 50% bonds is therefore unlikely to generate income of 4% today.
Steven Cameron, pensions director at Aegon, adds: "The 4% 'sustainable income' rule was developed in the US in the 1990s, at a time when interest rates were significantly higher.
"More recent studies in the US and UK have brought this figure down, but any attempt to come up with a single number will never work across a wide range of clients with different life expectancies, risk appetites, and capacity for loss."
Mr Cameron adds that people who have assets to fall back on outside of their pension may be more comfortable with a higher probability of their pot running dry in retirement, while those relying on it as their sole income will want more certainty. This sentiment was echoed by Simon Massey, a wealth management director at MetLife UK.
According to MR Massey, those who have 'cash reserves' are better placed to ride out market falls.
He adds that recent research by MetLife UK found around three-quarters of over-45s agree that guaranteed income for life is important, but the trouble is that it is difficult to put a figure on what is a sustainable level of income.
"Those who want to do not want to buy an annuity but would also like some piece on mind should putting some of their pot into guaranteed drawdown," suggested Mr Massey.
This story was originally written for our sister magazine, Money Observer.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.