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Is 4.7% the new magic number for sustainable pension withdrawals? · On The Money

• 0:03
  Kyle Caldwell: Hello, and welcome to on the money, a weekly look how to make the most out of your savings and investments. So in this episode, we're gonna be covering the dilemma of how retirees can approach taking money out of their pensions while ensuring that their pension pots last as long as they do. The strategy that's become very famous in the way of the pensions is the 4% rule, which may now be rebranded the 4.7% rule, which we'll talk about in this podcast. Now the theory is that if you start off with four percent or maybe now 4.7%, you take that out of the start retirement and then increase withdrawals each year in line with inflation, then your investments can, in theory, stay the course for thirty years. And those withdrawals continue irrespective of how stock markets behave.
• 0:59
  Joining me to discuss this topic is friends of the podcast, Craig Rickman, who is personal finance editor at Interactive Investor. Before we delve into it, Craig, did you know that this is the a hundred and fiftieth episode of On the Money podcast?
• 1:14
  Craig Rickman: I didn't until about five minutes before we came on and you told me, but one achievement.
• 1:20
  Kyle Caldwell: You've been on the podcast quite a few times. What's different this time?
• 1:25
  Craig Rickman: I can't think of anything. Is that is that a new jumper you're wearing?
• 1:29
  Kyle Caldwell: It is a new jumper, but we're also now filming the podcast. And each episode from now on, we'll there'll be a video version on YouTube. And that's in response to feedback we've had. And we've had some listeners get in touch to say that they would like to see a video version. So we're gonna accommodate that going forward.
• 1:48
  But what's not gonna change is that you'll also still be able to listen to us on your preferred podcast app or through ii.co.uk. And also what's not changing is the pop the podcast will be published every Thursday, and the topics that we cover, they're gonna be related to investments and pensions as they have been for a 150 episodes. And each episode gets under the bonnet of a particular topic or theme, and we discuss it for around twenty to twenty five minutes. And ultimately, we're we're here to save listeners. We're trying to help investors make more informed investment decisions and to hopefully learn a thing or two from our podcast.
• 2:27
  So so Craig, let's now get on to this episode's topic. So the 4% rule or maybe now it's the 4.7% rule. Take let's take a step back. Could you explain where this rule came from and what what is it based on?
• 2:44
  Craig Rickman: So this was devised by a US financial planner, Bill Bengen, back in 1994. And he calculated that if you were to withdraw 4% of your portfolio every year, adjusted annually by inflation, your money should last at least thirty years. Whereas, I most people would span their retirement, I guess, you retire particularly early or you live for a particularly long time. So this was based on a portfolio comprising 50% equities and 50% bonds, kind of a balanced portfolio, I guess, balanced portfolio leaning more towards the cautious side. And it was modeled on market performance over thirty year rolling periods from 1926.
• 3:35
  And, yeah, like you say, since then, it's become a a widely used rule for for retirees and for financial planners.
• 3:43
  Kyle Caldwell: And it's a so it's a waste based case scenario, isn't it? The 4% rule or maybe it's now 4.7, which will come on too. And it assumes that you take capital out of the pension in terms of the total returns rather than it being based on, say, a natural income approach?
• 4:01
  Craig Rickman: That's right. Yeah. I mean, it's it's seemed as a as a safe withdrawal rate. I think that's that's something that it's that it's also known as. So, yeah, looking at a total a total return approach, and it, yeah, it doesn't take account of adjusting withdrawals in light of of changing market conditions.
• 4:22
  Kyle Caldwell: And I've seen over the years comparisons being made between this rule and the potential retains you can get from annuities. I mean, for me, though, there's risks compared in Apple's repairs. Could could you go into a bit more detail about why that's the case, Craig?
• 4:39
  Craig Rickman: I can. Yeah. So often when comparisons are made between the 4% rule and annuities, it's based on a level annuity. So if you if you buy an annuity, which is a guaranteed income for life, essentially, you swap your your pension savings for that feature. You you you've you've got various options that you that you can choose.
• 5:04
  So you can choose just to have an annuity, the income paid for just your life. You can have the the the money passed to a spouse. If you were to die, you can choose guaranteed periods. You can choose to have it rated every year. But each feature that you build on reduces the amount annuity rate payable that's payable.
• 5:22
  Sorry. So the danger we're comparing the 4% rule with a level annuity is that it doesn't take account for the fact that the 4% rule has increasing income every year. So it's designed to increase in line with inflation. So that's the sort of the the Apple and Pairs element. If you were to look at I mean, you were to buy a level annuity right now and let's say you're 65 years old, you could probably get somewhere not far away from 8% a year.
• 5:50
  If you wanted, an escalating annuity, so one that keeps pace with inflation, that income would drop down initially to the early 5%. And so there's there's there's quite a big difference there. But there are other obviously, there are other problems with comparing, you know, annuities with 4% rule. I mean, with the 4% rule, you're keeping your money invested, so you still have flexibility over withdrawals. There is the the possibility of of leaving a legacy for someone.
• 6:20
  Obviously, if that money passes to someone other than a spouse or civil partner after eight and you pass away after April 2027, there could be some inheritance tax to pay. But still, there is the facility to do that, and there's you know, you you get more flexibility with drawdown. So although you can kind of understand that comparisons are made, and the comparisons will always be made between, you know, when you're looking at income drawdown annuities, you do have to be a bit careful about how you do it.
• 6:43
  Kyle Caldwell: And for me, you know, with annuities, the things that bear in mind is that it's a irreversible decision. Once you take out an annuity, you you can't change your minds. The fact is that as you get older, you do tend to get better rates with annuities. And so I think it's just weighing everything up and, you know, potentially mixing and matching works for some people, but also waiting that bit longer as well to get that extra level of income.
• 7:10
  Craig Rickman: Yeah. Yeah. That that's something that or approach that some people take is to use drawdown in the early stages and then move to an annuity as they as they get older. But, you know, it's it's I guess the good thing with it is you you get to choose the way that you wanna do it.
• 7:26
  Kyle Caldwell: Let's now get to the 4% rule and whether it is now being rebranded the 4.7% rule. So the reason why is because the author of the research, William Bengen, he's written a new book. It's called A Rich of Attirements Supercharging the Four Percent Rule to Spend More and Enjoy More. So, essentially, Bengen has done new research, and he upped the number of asset classes he based his research on from two to seven. And in a nutshell, he says if you have a more diversified portfolio, then you can do a lot better, and you can start off with 4.7%.
• 8:08
  I have seen that he said the the average that someone could start off with is more like 7%, but if at at 7% level, it's a fifty fifty chance whether your retirement pot will last the course of thirty years. What are your thoughts, Craig, on Bengen's updated research?
• 8:28
  Craig Rickman: I think one of the one of the interesting things is a few years ago or back in 2021, Morningstar did their own examination of the 4% rule, and actually reduced it. They pared it pared it down or pared it back to 3.3%. And so I think it it it sort of illustrates that any kind of fixed withdrawal rate in retirement should only ever serve as a as a guide. Clearly, the the Bengin's update, is is so it was 30 before he did the original analysis. So his update, as you say, is based on a a wider spread of assets.
• 9:08
  So that's one element. I guess I guess the other thing is, you know, other aspects like economic conditions and and and the outlook for markets for inflation, those things can change as well. So I think my view is that it it it illustrates that it yeah. It's it's it's a starting point for most people. But it's really important to not only personalize your your withdrawals in in drawdown, but also review them regularly, to fit with, you know, what's what's, you know, the the things that you want to achieve as an individual, plus taking into account what's going on economically as well.
• 9:43
  You just touched on a couple of points that are critical of the 4% rule. Sorry. I'm gonna say it again.
• 9:52
  Kyle Caldwell: The 4% rule has its critics, and you just mentioned a couple of those points. So, obviously, no one knows what future investment returns are gonna be. No one's gonna know in the future the level of inflation. And if we have a a really sustained period of of of high inflation, then that's not compared in apples with with apples. Oh, sorry.
• 10:14
  Say again. Ugh. Don't get me apples away. Right. You've just mentioned, Craig, a couple of potential flaws in the 4% rule.
• 10:23
  It does have its critics, and you've just mentioned one of them is the no one knows what investment returns or what the inflation rates will be in the future. All the commentators have pointed out that one thing to bear in mind for UK savers and investors is the is the the research is based on the performance of The US stock market and US bonds. And over the very long term, The US stock market has done better than The UK stock market, so that might actually flatter the the the level of the safe withdrawal rate that Bengen has come up with. It also doesn't take into account fees, which is the only thing that investors can control at the outset, and it also assumes thirty years of withdrawals. And, of course, we now we know that some people live longer than that and have longer periods in retirement than thirty years.
• 11:16
  And as you touched on, Craig, it's not personalized.
• 11:20
  Craig Rickman: Yeah. Yeah. And one and one of the other things well, I'll come into that in a sec, but one of the other things it doesn't take into account of is tax. And we know that managing tax bills in retirement is really important. You know, the the the saga that's been going on around tax free cash illustrates the value that investors put on that element.
• 11:38
  So managing tax bills in retirement is is really important, but the Bengen rule doesn't take account of that. So if you're making withdrawals from income drawdown other than the the the tax free element, then that is added to your income tax bill and taxed at whatever rates or whatever tax band, whether it's 20%, 40%, or 45% that it falls into. However, if you're if you're taking income from an ISA, then you get to keep the lot. So there's there's that consideration as well. But, yeah, going back to the the the personalization, that's, you know, that's that's the that's the thing for everyone.
• 12:13
  Everyone who is in retirement has their own set of unique circumstances, and that goes back to the the points earlier we were talking around annuities and drawdown and and the decisions that that that people make and and how they arrive at those, but it's about finding out what's the right thing for you. And for some people, drawing 4% every year, uprated, annually by inflation might be the right thing to do. But for others, they might wanna take a bit more, might wanna take a bit less. It depends on your personal circumstances, attitude to risk, capacity for bear losses, and and maybe other, you know, other income sources as well. So there's there's quite a lot to consider when sort of choosing what what rate of income you wanna draw from your investment portfolio.
• 12:56
  Kyle Caldwell: And as I mentioned at the start of the podcast, the theory is that you continue to take a level of income that goes up with inflation, starting off with 4% or 4.7% now, irrespective of how your investments perform. However, you don't have to follow that to the letter. You could, in theory, make adjustments. You could take more in good years, take less in bad years. But, Craig, I mean, in a former life, you were a financial adviser.
• 13:25
  How how difficult is that for someone to do in practical terms?
• 13:28
  Craig Rickman: I mean, it depends on how reliant you are on that portion of income. I mean, if that is if so, if you're heavily reliant on that income in retirement, so let's say you get the state pension and you use the rest in drawdown and you need a certain amount every year to live the lifestyle that you want, then it's gonna be very difficult to to to sort of take a a lower a lower withdrawal rate because then you have to consider, you know, what you're gonna give up during during those years. What aren't you gonna be able to do? It might be slightly easier for those who have more guaranteed income sources. So let's say they've got some defined benefit pension, maybe they bought an annuity with a portion of their of their pension pot, then the the facility to have that flexibility to adjust withdrawals, that that might be more of an option to them.
• 14:23
  So, again, it's it's sort of balls back to your your personal circumstances. But, yeah, I mean, some people is not it's just not that simple, is it? It's not as simple as just saying, well, I'm just gonna take less.
• 14:33
  Kyle Caldwell: And although we don't know how investments will perform in the future, I think it's fair to say that, you know, 4.7 a year, it's not too onerous a challenge. It's not, you know, we're not saying it's gotta be 10%. I mean, that would be a very, very hard thing to pull off. But after even after fees, you know, the long term average return of of of UK shares based on, like, a 100 years of historical data, which Barclays published, I think it's about 5.5% a year in real terms UK shares return. So for me, I don't think it's it is challenging, but I don't think it's, like, a a really difficult challenge to achieve.
• 15:15
  Craig Rickman: No. And I think, I mean, as many people have been sort of saying for years that that 4% is very is that is it is a cautious is not overly aggressive in any sense of the word when it comes to drawing a retirement income. Taking 4.7%, if we take into account Bengen's sort of updated rule, it's a bit more aggressive. It means that your investments will have to perform a bit, you know, better than they would have done otherwise. But still, it's yeah.
• 15:43
  Exactly like you say. We we're not talking that you need these sort of outsized returns
• 15:49
  Kyle Caldwell: in order to make your money last. So it's it it, you know, it still seems palatable. And in terms of what people are actually doing in terms of how much they're withdrawn from their pensions, what does the data tell us, Craig?
• 16:04
  Craig Rickman: Well, I've got some numbers here. So this is from the Financial Conduct Authority's most recent retirement income data, and this looks at regular withdrawal rates based on pot size during the twenty twenty four, twenty five tax years, the previous tax year. So let's have a look at, what people have been doing, with, with pots that are £250,000 or more. So, the two most sort of popular groups of of withdrawal rates, number one is taking between 23.99% a year. The second most popular is less than 2% a year.
• 16:48
  Might as well cover cover the third. So the third most popular is between 45.99% a year. So I guess if if we looked at that, you can see some correlation with with the Bengen rule, perhaps. These figures don't tell the full story because they only look at individual pot sizes and not in what individuals are doing as a whole. So it's possible that someone could have some some smaller pension pots as well that they're taking bigger withdrawals from, and that could so it could be distorting the figures because it's only looking at individual pots.
• 17:23
  But it certainly gives us some clues on on what people are doing, and by and large, people with bigger pots are tending to be reasonably cautious with their withdrawals.
• 17:32
  Kyle Caldwell: Because it also reflect the very start of retirements. It's really important that people don't wanna get off to a bad start. Bengen's research does indeed show that the first decade is very important. If you retire into a bear market, for example, so say your investments fall by 20%, then you're gonna need a 25% gain to get back to where you were. And it's pound cost averaging in reverse.
• 17:57
  It's called pound cost ravaging. Could you explain that a bit more, Coo?
• 18:01
  Craig Rickman: Yeah. I've you've I mean, you've touched on something really important there when it comes to managing withdrawals in retirement, and that's the early years, the first three years, the first five years, the first ten years. Because if you get off to a to a bad start, and that could involve that markets are performing poorly or your withdrawals are overly aggressive, that can have an enormous impact on ultimately how long your money lasts. So, yeah, one of the key risks, as you mentioned, is is pound cost ravaging, and that's that's the most acute in the early years of retirement. And, essentially, if you if you continue to take withdrawals from equities during periods where markets are falling, that can affect how long your money can last.
• 18:46
  So if it looks at if we look at a very, very simple example. Let's say you had a pot of 250,000 and you're drawing 4% a year, which is £10,000. There's a market slump, and the value of that drops to 200,000, and you can still continue to take £10,000. Now your rate of withdrawal, even though in monetary terms, it's the same, has jumped up to 5% a year. And, you know, the the bigger percentage that you're taking out of your pension, the harder it has to work to last as long as you do.
• 19:21
  So, yeah, it's really, really important to think about how to manage your pension withdrawals, and this goes back to that personalization thing, how to make it sort of specific for you, and also take account of of what's going on economically as well.
• 19:38
  Kyle Caldwell: So essentially, Craig, if your investments plummet, but you then decide, actually, I'll take less, I'll withdraw less, then you're giving your investments greater opportunity to recover their poise over time.
• 19:50
  Craig Rickman: That's right. Yeah. I mean, alternatively, the other option is to pause withdrawals from shares completely.
• 19:58
  Kyle Caldwell: In terms of how you set up a portfolio, there are certain types of funds that fit the defensive description. So one of those is money market funds. So these these offer like a cash like return. So they invest in very low risk risk bonds that have very short term lifespans. And at the moment, the yields that you can get off money market funds are around 4%.
• 20:22
  These funds will typically yield a yield whatever the Bank of England base rate is, give or take. All the defensive options include wealth preservation trusts. I've spoken a lot about these over the years, including on the podcast. So there's a small number of investment trusts that invest in a very cautious manner. They have a lot of defensive armory.
• 20:45
  They'll invest in low risk bonds, have some exposure to gold. They'll have around a third in shares, so that's not much compared to the typical sort of portfolio. And three examples of wealth preservation trusts are capital gearing, rougher investment company, and personal assets. If you look at the historic performance of all three of those, when stock markets are plummeted, they've held up very well in terms of their overall total retains. They've managed to protect capital.
• 21:16
  They've done their job as being defenders in a well diversified portfolio. Other cautious funds you'd find in the mixed investments, naught to 35% shares investment sector, and also the mixed investment 20 to 60% share sector. So those are sorts of investments as well as bonds as well that should be considered as sort of a defensive part of a portfolio. I've mentioned money market funds, Craig, which are a cash like type of investments, But there's also cash can also be utilized as as part of a diversified portfolio as well. I've seen you write about this cash pot trick.
• 21:56
  Could you talk us through this? This is where you my understanding is you then you put a certain level of income in cash that you can then dip into when stock markets have a lean period.
• 22:08
  Craig Rickman: Yeah. Sure. So like I was saying earlier, you know, if if stock markets have have fallen, your portfolio is falling in value, you know, one way is to, you know, to to reduce the amount of income you take, or you could just pause withdrawals completely to give your to give your pot the best chance of of of recovering or recovering quickly. And one way to do this is to have a cash buffer. It can be within your pension, but it could be outside as well.
• 22:37
  And the idea is to keep roughly sort of two to three years expenditure in cash so that should a market slump arrive, you can pause withdrawals from the equity portion of your retirement portfolio, dip into your cash, and that should offer some protection. And again, give your money a better chance of of recovering quickly because you're not drawing market out sorry, not drawing money out. So I can wrap the table there. That should give you a a better chance of your retirement portfolio recovering more recovering more quickly because you're not drawing money out when stock prices are low. So it can be an effective way to do things.
• 23:24
  I guess one of the things to remember when keeping a cash pot is if you deplete it for any reason, is to remember to top it back up again so that you're protected should, you know, further market falls arrive in the future.
• 23:37
  Kyle Caldwell: And the other strategy that I often see cited is the natural yield approach. So this is where you have a portfolio that's predominantly focused on income producing investments, and whatever the yield is, so whatever the underlying income that's being generated from the portfolio, whatever that is each year, then that's the amount that you take. Because if you do this, then you're not harming the capital growth of the portfolio. Yeah.
• 24:05
  Craig Rickman: I think Yeah. I think in an ideal world, that's that's what that's what people would use if you could because what most people are looking for is a way to generate a regular income in retirement and preserve their capital. I guess one of the the the the problems with the natural yield approach is the the the certainty of income or the lack of certainty of income. So, you know, while if if you're the companies that you're investing in or the trusts, investment trusts are paying good dividends now, there's no guarantee that those yields will will continue. I mean, you hope so, but but you don't know.
• 24:42
  So but but but still, it might be suitable for those who aren't relying on that portion of their income. So sort of go back to what we were saying earlier around, you know, people with different circumstances. Unless you are heavily reliant on that income, then then that can be a good approach.
• 25:00
  Kyle Caldwell: In terms of trying to generate a consistent level of income growth at retirement, I think I mean, obviously, there's no guarantees, but I think the investment structure is better suited rather than open end of funds. And the reason why is because with investment trusts, the investment trust can squirrel 15% of income generated each year away. That's income generated from the underlying investments. And then if stock markets have a rocky patch, there's less dividend income being produced, then investment trust can dip into those reserves, and then they can maintain or increase their dividend payouts during lean periods. So they're called investment trust dividend heroes, and there's there were 20 that have increased the dividends for more than twenty years, and 10 have increased the dividends for more than fifty years.
• 25:52
  And a couple of the examples of those 10 are City of London, Bankers, and Alliance Whitten. Of course, there's no guarantees that these dividend streaks will continue, but because of the structure, there's more chance than than a continuum rather than an open end of funds. With an open end of funds, all of the income that's generated each year is retained to investors. They can't hold anything back. So if there's less income coming in, then they'll be paying less income over time.
• 26:21
  The the final point I wanted to make, Craig, and and ask you about is I spoke earlier about the sort of, like, how you can have a defensive buffer in the portfolio in terms of target and certain types of funds or investment trust to invest in a defensive manner. But there's also a danger of being a bit too cautious, I think, being a bit too defensive because at the end of the day, you want your retirement pot to last. You want it to grow. It could be a thirty year or more time horizon. So it's very important that you also have enough exposure to growth producing assets as well.
• 26:57
  Craig Rickman: Yeah. I think that the the first thing to say around that is attitude to risk is very much a personal thing, and it will depend on, you know, how much risk that you are comfortable taking and also the levels of of losses that you can you have the you have the capacity to bear. But the other side to that is if you're looking to, you know, take an income in retirement and you want that income to be increasing every year with inflation using something like the Bengen rule, whether it's 4% or whether it's 4.7%, then you're you're gonna need your portfolio to grow. Growth is is gonna be really important. So it's having a, I guess, a combination of of that your money growing that you can then take rising income from.
• 27:43
  So, yeah, fifth 50% equities would be sort of, I guess, sort of the middle to the more cautious side of things. There are there are many people out there who who will be, you know, more comfortable or be comfortable with taking more risk than that. So, yeah, again again again, it's a personal thing, but it's but it's really important that your retirement portfolio is geared up to grow.
• 28:09
  Kyle Caldwell: So, Craig, that's what we've got time for today. I think I've went a little bit over our sort of aim for twenty to twenty five minutes each episode, but I think hopefully if an exception can be made here, because it's such a huge topic. We wanted to cover it as comprehensively as we could in the time allowance. And I hope those that tuned in, you've learned a thing or two, and it's been useful. My thanks to Craig, and thank you for listening to this episode of On the Money.
• 28:37
  If you enjoyed it, please follow the show in your podcast app. And if you get a chance, leave us a review or a rating in your podcast app too. We love to hear from you. You can get in touch by emailing otm@ii.co.uk. And in the meantime, you can find more information and practical pointers on how to get the most out of your investments on the Interact Investor website, which is ii.co.uk.
• 29:01
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