Making Your Money Last in Retirement

Should you follow the 4% rule?

In light of the 2017 Spring Budget, Tim Bennett explores how you can make your money last in retirement and considers whether or not you should follow the 4% rule in life after work.

Running out of money has to be one of the bigger fears facing most retirees. With defined benefit pensions becoming a thing of the past, more and more of us are reliant on making our personal pension and non-pension assets last. Whether or not they will depends on a number of factors, one of which is the rate at which you deplete your assets every year by drawing off an income. Determining the appropriate rate is where planning comes in to play:

Getting Started

Let’s say you have a pension pot of £200,000 in retirement. The first thing you will need to do is try to answer a few key questions:

  • How long do you anticipate needing an income for?
  • What rate of real return (i.e. taking inflation into account) do you expect from your assets?
  • Do you expect to have to draw off any large lump sums that will deplete the pot?
  • Are you expecting to receive any other income (e.g. from a State pension or property)?

These are not all straightforward questions to answer but trying to do so is important as the answers will directly influence how long your £200,000 will last.

The Simplest Answer

Were you to leave the £200,000 in cash, earning zero real (post-inflation) return and anticipating that you will make no withdrawals other than the income you need, the calculation would simply divide your capital by the number of years you expect to need the money for. For example, you would like an income for at least 30 years, therefore your £200,000/30 is £6,667 per year. Over 25 years, the answer is £200,000/25 at £8,000, and so on.

However, in reality you would be more likely to invest the original sum so that it hopefully earns an above-inflation return. If this is the case, the calculation changes.

The Impact of Different Rates of Return

Introducing an annual return on your money is more realistic for most investors but also complicates things; since we do not know what rate of return we can earn in advance, say from assets such as equities, this income needs to be estimated. The following chart shows how much you could afford to draw off your fund at three assumed annual growth rates over a period of 30 years.

Introducing an annual return on your money is more realistic for most investors but also complicates things

At a rate of 4%, you could afford to pull out an income of approximately £11,500 per year, but rather less than that at 2% growth and more at 6%. But which one is right? A famous study claimed to have the answer.

The 4% Rule

Devised by William Bengen, the 4% rule came from a study on the performance of a 60% equity, 40% bonds portfolio. I will side-step all of the detail here to get to the conclusion: over a 30-year period, a withdrawal rate of 4% per annum of a mixed fund should not deplete it within 30 years, provided you adjust for inflation and any dividend or interest distributions received during the year. This conclusion would broadly support the middle band of the chart above.

Does It Work?

Things to bear in mind about the famous study and its well-publicised result are:

  • When the study was conducted, inflation and interest rates were higher than they are now
  • Life expectancy is rising all the time
  • Bengen’s 60:40 equity/bond portfolio may not mirror your own.

In short, 4% may be too high in some periods and market conditions, where return rates and bond yields are low. Equally, it may be too low in others where returns rates are higher; after all the aim is to run down your fund at a rate that makes it last but also doesn’t short-change you too much, especially during the early years of retirement.

My conclusion would therefore be that whilst the 4% rule is a useful starting point and benchmark, a wise investor will want to actively monitor their retirement fund and expectations as market conditions unfold and adjust their rate of withdrawal accordingly.