One of the questions we hear time and again is will I run out of money in retirement? Unfortunately, nobody can predict the future so there is no definitive answer. Everyone’s personal circumstances are different and (to be blunt) nobody can predict when you and/or your spouse will die.
That said, it is possible to reduce the risk of running out of funds. Those who purchase an annuity effectively purchase a fixed pension income for life but that comes at a cost (see below). For those who choose the potential benefits offered by pension drawdown the risk of running out of funds can be a major concern.
If choosing pension drawdown you need a plan that covers a range of scenarios. You need to understand the potential threats to your retirement income and how you could deal with those threats. If it appears your risks of you running out of money in retirement are increasing there are potential solutions but taking appropriate action as soon as a problem is identified is critical.
Why You Need A Plan
Both the annuity and pension drawdown options allow you to take a tax free sum (up to 25 percent of the value of the fund) at age 55. With drawdown, the balance of the fund is available as (taxable) income that may be taken as you wish.
Without a plan how are you going to measure progress? As you move through retirement you need a reference point to refer back to. Are you on track? Or is there a shortfall? Are future investment returns likely to fill any gap? Can you afford to spend a little more or do you need to cut back on expenditure?
Ideally, the plan should be in place before your retirement. It should cover how much is in your fund, what is your expected short and medium term expenditure. The plan should account for your state pension income but should cover what are you expecting to withdraw from the fund and the fund growth you are expecting.
There are however several problems with any plan. Firstly, there is no end point you can work too. You don’t know when you or your spouse will die.
Secondly, by definition, if you are considering retirement you are getting older and that means the chances increase your health may fail. The NHS will cover costs of treatment but long term care is more of a problem. If you have a reasonable level of personal wealth state support may be minimal.
As you get older, and with limited potential pension income the value of your assets may deteriorate. You may currently complete all the small to medium sized DIY jobs associated with maintaining your property but this will be harder as you get older. You may buy yourself a new car as you approach retirement but this will age as you do. Your plan should, therefore, include something to cover repair/replacement of major assets
You should at least attempt to predict future economic conditions. One of the major threats to a retirement fund is the impact of inflation. Judging what will happen to inflation over the long term is difficult. However, if you have a financial adviser they can run through various scenarios with you and the potential impact on your pension fund.
No plan can be perfect and there are many economic, political and social issues that are completely beyond your control. However what you can control is how much you withdraw from your pension fund and when you make that withdrawal.
Capital Withdrawal Profile
Once you are 55 you may make withdrawals from your fund as income as you wish, you may even withdraw the full amount. Each withdrawal you make will be taxed at your marginal tax rate (20%, 40% or 45% depending on your income). In drawdown, it is vital to both manage your pension fund and your withdrawal profile to ensure you do not run out of funds in retirement.
We have written about (theoretical) safe withdrawal rates from a pension fund elsewhere on this blog. The long held rule of thumb is an annual withdrawal rate of 4% of the value of a pension fund per annum (£10,000 assuming a £250,000 pension fund) will deliver high confidence a pension fund will not run out during retirement.
The 4% figure makes a wide range of assumptions and has come under attack by a number of financial experts over the years. It takes no account of an individual’s specific circumstances and should be used as no more than a general guide. The 4% figure is a flat rate, it does not cover the more realistic case of an individual taking more in the early years of retirement than the later years.
Capital Withdrawal Timing
It is critical to understand the implications of taking income from a drawdown fund when markets are down. With the capital value of the fund falling taking withdrawals further depletes the fund making it much harder to recover to the original capital value when the markets turn.
There are two possible solutions to this problem. The first is to hold sufficient cash to avoid taking income from the drawdown fund while markets are down. The second is to maintain a well balanced portfolio. History shows markets rise and fall the challenge is to maintain the right investment portfolio and that generally requires a level of expertise.
The Potential for Capital Erosion
The above takes no account of capital growth or inflation. Over the medium to long term you should expect some growth on your investment. The question is how much growth above the actual rate of inflation over the same period.
The potential for capital erosion can be difficult to assess. As an example, if an individual withdraws an income of £10,000 in a single year from a £250,000 drawdown pension fund then to maintain the capital sum (£250,000) the invested drawdown fund needs to grow roughly five percent (above inflation) over that year.
If in the above example due to poor choice of drawdown fund or investment profile the investment only grows by three percent then the loss over the year on the capital sum will be approximately £3,000. The impact of an invested drawdown fund performing poorly over several years can, therefore, be significant.
A 4% annual withdrawal on a £250,000 fund would deplete the fund by £10,000 to £240,000. If the growth is then less than inflation this would further deplete the fund(by £3000 in the above example). The compound effect of withdrawals plus growth below inflation on the pension fund can be significant.
Fees and charges can also have an impact on the value of a pension fund and should not be underestimated. Choosing the wrong drawdown arrangement with higher than average fees can deplete a pension fund by tens of thousands of pounds over the long term.
You may reduce your exposure to investment risk at any time by using part (or all) of your remaining drawdown pension fund to purchase an annuity. Purchasing an annuity will secure a fixed income until death.
In August 2016 annuity rates hit an all time low and they have struggled to recover since. It is therefore crucial to time the annuity purchase appropriately and research the best rates available at the time across a number of providers. Annuity rates can vary considerably according to the provider and the performance of financial markets at the time.
If you have a plan then it should be possible to measure your current position against that plan and take appropriate action. Your financial adviser (if you have one) and/or drawdown provider should provide regular updates on the performance of your investments. The quality and regularity of these reports can vary depending on the provider.
A good financial adviser will prompt you to consider action if it is appropriate. If working without advice you will need to review reports, spot trends and consider market conditions yourself.
Everything may be on track. Or you may need to re-balance your portfolio of asset classes. You may need to reduce your withdrawals or secure some extra income. Downsizing may be an option for some.
There is always a solution although some may be unpalatable. Building a strong pension fund over a working lifetime is the ideal scenario. Of course, the realities of life often get in the way and it is not always possible to build the pension fund you may wish for. If so it is even more important to have a plan and to monitor progress closely against the plan.
The past is not a guide to future performance. This blog is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investment or course of action. Tax rates apply at the time of writing and are subject to change. Tax rates apply to England and Wales.