In this diary entry, Tim Jablonski, EValue Product Director, looks at strategies that apply a constant withdrawal - or an inflation-adjusted constant withdrawal.
As a starting point to the series, we will look at Bengen’s 4% rule, the most well known ‘Constant Withdrawal’ strategy.
While exploring the different drawdown strategies, we will be using the six criteria below to establish the merits of each, to help you understand the pros and cons, as well as, the risks associated with them.
- Simplicity - how easy is it to explain in layman’s terms
- Flexibility - how well does it respond to your changing circumstances or any one-off spending you might need
- Durability - to what extent can I stick to this process in various economic circumstances
- How easy it is to manage - would you need the help of a financial adviser to implement it
- Cost - including fund cost, product cost and advice cost
- Investment performance - critically important if you want as good an income as possible.
Watch Tim’s latest video diary entry now:
In 1994, William Bengen introduced the 4% rule. Bengen based his study on the longest possible sequence of US historical market data available, from the 1920s depression to the end of the 20th century. He proposed that retirees with a portfolio of minimum 50% shares could withdraw 4% of their retirement pot in the first year and then adjust for inflation in the subsequent years safely (i.e. with virtually no risk of running out of money) for up to 30 years.
A client has £1,000,000 in their pension pot and decides to withdraw £40,000 each year.
So, £40,000 is withdrawn in year one. In year two, the inflation rate over the first year would be added on to give the retiree their year two withdrawal figure. If the inflation rate was 1.8%, £720 would be added (1.8% of £40,000), and £40,720 would be withdrawn for the second year’s spending. This process is repeated each year to get that year’s withdrawal amount.
While there are benefits in adopting simple rules of thumb, Bengen's approach has a number of significant shortcomings that anyone advising on drawdown strategies ought to be aware of. In our mind, the 4% rule should be considered a thing as dead as the Dodo.
Taking this approach into consideration
Simple to implement
Potential for a consistent spending level year to year if you don't run out of money. This is a possibility though, as 4% is an historic number from a different country in different economic conditions to today’s and you could be unlucky with market timing
By adjusting for inflation you maintain purchasing power.
The 4% withdrawal is predicated on a very flimsy linkage to the underlying investment strategy and its prospective return which must have a major impact on the level and sustainability of withdrawals
Amount withdrawn takes no account of the value of a retiree’s portfolio or its performance making this approach very vulnerable to sequencing risk i.e. a series of bad returns in the early years of retirement
Times are different, economies are different, prospective returns are very different
The 4% rule is a naively derived statistic based on an historical back-test with overlapping 30-year periods which are not independent.
Scores on the doors
Simplicity - high score - quite easy to explain - 9 out of 10
Flexibility - strictly speaking reasonably low, since the spending is fixed each year so doesn’t allow for one-off requirements; however, it does increase with inflation, which allows a little more flexibility - 2 out of 10
Durability - well, on the one hand it’s a rigid rule so easy to apply in any economic market; however, if the withdrawal rate is too high, then the probability of running out of money before the desired time period is significant. And EValue’s analysis shows that 4% is too high and that the probability of running out of money within 30 years is 69%1. Also, if you live longer than the time period on which your rate has been calculated, the chance of running out of money is higher again. Therefore I’d give this a low score of 2.5 out of 10
How easy is it to manage - well, it’s naive and easy. The only tricky part of managing this approach is to find out what inflation is and apply that as an increase each year. On grounds of simplicity it earns a high score of 8.5 out of 10.
Cost - doesn’t really need an adviser or modelling tools - blind faith is all that is required. So no cost there, and provided you’re in good, low-cost funds, you should be OK. With this proviso, it scores 9 out of 10.
Investment performance - this is a significant defect of the approach, and it is quite extraordinary that a fixed withdrawal rate can be set without any serious reference to an investment strategy, and that withdrawals continue at the same level without any reference to investment performance. It is hard to award any score above zero but a charitable 1 out of 10 will be awarded for suggesting that at least 50% of the portfolio needs to be in equity.
If you take an average of the scores, Bengen would get 5 out of 10 but taking account of the serious deficiencies and the significant risk of retirees using this approach running out of money, 5 seems very generous. Realistically, and taking account of our earlier reference to “dead Dodos” 3 out of 10 seems more appropriate.
So what next?
Next week, Tim will be looking at strategies that apply a ‘constant percentage’ when withdrawing an income in retirement.
Tim will be hosting a special webinar “The Tale of Two Retirees” with Bruce Moss, EValue Founder, on Tuesday 9th June, to bring together all that has been shared throughout the series.
Book your place now;
1 Forecast using EValue’s economic scenario generator, Insight, and EValue’s DrawdownForecast API. Fund allocation is 50% UK Equity and 50% UK Gilts; no charges; 4% withdrawal increasing in line with UK CPI.