Perhaps the biggest challenge posed by pension freedom is ensuring clients spend and invest their savings in a sustainable way, writes Tom Selby.
But with interest rates – and hence bond yields and cash deposit returns – persistently low, coupled with the seemingly inexorable rise in UK life expectancy, do the old retirement income strategy rules still hold true for today’s clients?
What is the ‘4% rule’?
American financial planner Bill Bengen postulated that retirees with a diversified portfolio (50% in equities, 50% in bonds) should be able to take out 4% of the initial balance, adjusted for inflation, throughout retirement and be confident their pot would not run out. He reached this conclusion based on rigorous analysis of historical data, going all the way back to 1926.
There are two important things to note about Bengen’s rule. First, it was never actually a 4% rule at all – Bengen said 4% should, based on historical returns, last for 30 years in retirement.
His “absolutely safe” initial withdrawal level was 3%, ensuring the longevity of the portfolio is “never less than 50 years”. This is worth bearing in mind in a world where one in three babies born in the UK today are expected to live to 100.
Second, Bengen’s research is based on analysis of historic investment returns. That is not a criticism (we can, after all, really analyse only what has already happened), but it does frame the debate around the appropriateness of the rule in today’s low-yield environment.
Why question it now?
Bengen’s 50/50 portfolio would have delivered returns in excess of 4% in almost every year between 1926 and 2011. At its peak in 1982, the portfolio’s average yield was 10.6%, according to Vanguard.
By 2011, it had dropped to just 2.8%. In addition, there are serious questions about whether the investment returns seen in recent history will be reflected in the future.
A report from consultancy McKinsey published last year makes particularly bleak reading. The analysis suggests the past 30 years or so has been a golden era for investing and that investors will seriously struggle to achieve similar returns over the next 20 years.
Total equity returns averaged 7.9% in the US and Western Europe between 1985 and 2014 – 140 and 300 basis points above the 100-year average.
Similarly, real bond returns in the same period averaged 5% in the US, according to McKinsey (330 basis points above the 100-year average) and 5.9% in Europe (420 basis points higher than the average).
In its “slow growth” scenario, McKinsey estimates total US equity returns will average 4%-5% over the next two decades (250 basis points lower than the 1985-2014 average).
Fixed interest returns could be just 1% (a massive 400 basis points lower), while even the “high growth” scenario sees the next 20 years significantly underperform the previous 30. The analysis for Europe is equally gloomy.
Clearly these are only predictions, but there are strong economic arguments to suggest future growth will be lower than we have seen in the past. And if both bonds and equities give you less, then it stands to reason that a 50/50 portfolio of the two will not last as long if a client keeps making 4% withdrawals.
Furthermore, a few years of bad returns at the start of retirement (known as sequencing risk) can have a hugely detrimental impact on the longevity of a client’s pension pot.
Pension freedom
This all matters more now because of the freedom and choice reforms, announced by former Chancellor George Osborne in the March 2014 Budget. Before this, clients in drawdown who had secure pension income below £20,000 had withdrawals constrained through a link to GAD tables.
With savers in capped drawdown only able to take 100% of GAD, and the GAD rate sat at 3% or lower throughout 2014, it was much harder for savers to exhaust their retirement pots.
While we have some data from both the Association of British Insurers (ABI) and Financial Conduct Authority on pension freedom, this is about as useless as a chocolate fireguard when measuring the sustainability of withdrawal rates. The ABI data for Q1 2016, for example, shows that 4% of pots had 10% or more withdrawn, with many taken out entirely in one go.
However, we still have no detail on the individual circumstances of these people, including whether they have other sources of income or more than one pension pot. Without this, we are fumbling in the dark trying to draw conclusions about consumer behaviour.
Limitations
Whether the so-called “safe” withdrawal rate is 4%, 3% or even 2%, the reality is neither Bengen nor McKinsey have a crystal ball. In fact, there is an argument to suggest the very idea of a safe, no-risk level of withdrawals is a dangerous fallacy, particularly if followed by clients not taking regulated advice.
Furthermore, such rules are unlikely to sit perfectly within the needs of most clients, who may need more income in certain stages of their life – particularly if they require long-term care – and less in others.
The one thing that is clear is financial advice has never been so important or valuable. In the past, most people needed to find the right annuity and that could have been the end of their advice needs (at least in relation to their pension savings).
Today, people using income drawdown need ongoing advice that might last 30 years or more into retirement. Advisers can play a crucial role in managing expectations and carrying out regular portfolio reviews to ensure clients’ pensions last the distance.
Tom Selby is senior analyst at AJ Bell
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