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The Drawdown Diaries: Episode 3 - Constant Percentage Methods

Author: Adam Robins
28 May, 2020

DD Episode 3 Header

In this diary entry, Tim Jablonski, EValue Product Director looks at withdrawal methods that apply a ‘constant-percentage’, outlining the key benefits and drawbacks of each, so you can help your clients make better financial decisions in retirement.

So, let’s begin by asking yourself a question. Do your clients need to ensure that there will always be money leftover in their pension pot? 

If so, withdrawing the same percentage annually based on the current portfolio value, ensures that their money won’t run out, as only a percentage of the current value of the portfolio is withdrawn. 

However, since the value of a retiree’s pension pot will change annually due to the ups and downs of the financial markets, the amount able to be withdrawn will also change each year, which could leave your client with a much lower income than required in times of poor market performance.

Also, annual withdrawals do not take into consideration ‘inflation’.Constant Percentage methods rely on long-term portfolio growth to mitigate the impact of inflation.

Example

Suppose your client wishes to withdraw 4% from the portfolio annually; with initial pension assets of £1,000,000, the income will be £40,000 in year one. However, for the second year, the amount withdrawn depends on the portfolio value at that point, which ultimately depends on the market conditions at the time.

Scenario 1- Rising Market

The pension pot at the beginning of the second year has grown to £1,200,000. Then the withdrawal for that year will be 4% of £1,200,000, or £48,000. 

Scenario 2- Falling Market

The pension pot at the beginning of the second year has fallen to £800,000. Then the withdrawal for that year will be 4% of £800,000, or £32,000.

 

 

Taking this approach into consideration

One advantage of this withdrawal method is its simplicity - you just have to multiply the client’s portfolio balance each year, by the withdrawal percentage

However, depending on market conditions and the rate of withdrawal chosen, there is a very real chance that the portfolio will decrease significantly in value.  Although there might seem to be some good news that a retiree will never run out of money, that might prove to be a technicality, as the pot is depleted, a only very small income may be able to be withdrawn from a very small pot!

The withdrawal amounts will always fluctuate with the portfolio’s value - meaning that your client’s lifestyle could be impacted. There will be less to spend in years when the portfolio value drops, and unless portfolio returns are good, there may not be enough in later years to keep up with inflation. 

Benefits

  • Constant percentage withdrawal strategies guarantee a client won’t run out of money as only a percentage of the current value of the portfolio is withdrawn
  • The approach is easy to understand and implement

Drawbacks

  • The amount withdrawn is linked to markets so that withdrawal levels can be volatile year to year.  
  • If the percentage withdrawn is constant, does not vary with age and is more than the long term return on the portfolio, the income will tend to decline as the assets are eroded during retirement. A better variant might have the percentage increasing with age to take account of the reducing life expectancy.
  • Less-volatile holdings like bonds can reduce the volatility, but not eliminate it, and will reduce the return on pension assets. For retirement income from drawdown to compare reasonably well with an annuity, the assets in drawdown need to perform well to overcome “mortality drag” i.e. the cross-subsidy inherent in annuity pricing from those retirees who die early to those who exceed life expectancy.

 

Scores on the doors

Simplicity -  unless the percentage varies with age, this approach to income drawdown is not difficult to understand and so scores 9 out of 10

Flexibility - the amount available to provide an income depends entirely on the investment performance from year to year and so lacks flexibility as it doesn’t even keep pace with inflation unless the long term investment return exceeds the constant percentage withdrawn by a sufficient amount. It is hard to see that any score here is justified 0 out of 10

Durability - the constant percentage withdrawal does at least ensure that money does not run out during a retiree’s life but the amount may reduce dramatically as the retiree becomes older and on death there is always money left over. A score of 5 out of 10 seems generous.

How easy is it to manage - although applying the percentage to the current fund is straightforward, choosing the right constant percentage to apply each year is very hard. It is necessary to estimate the investment return depending on how the fund is invested and if inflationary increases are required what the real return on the investments will be, as this is the constant percentage to be applied. So in summary, although superficially simple, in practice, the constant percentage approach is very hard to manage effectively. Score 1 out of 10.

Cost -  Advice will be required to determine the investment choice and the withdrawal rate, but thereafter if there are no plans to vary the percentage to be withdrawn, the ongoing management of this approach shouldn’t really require the help of an adviser or modelling tools - so maybe not very high costs there! However, if the focus is on retirement income, then the fact that on death potentially a substantial proportion of the fund has not been used for income, could be considered to be a cost. Assuming investment in good, low-cost funds, overall a score 5 out of 10 seems appropriate.

Investment performance - If stability of income from year to year is a priority there will need to be a heavy investment in bonds which will reduce the return. Given the “mortality drag” mentioned earlier, there is clearly a trade-off between stability of income and investment performance. We score this as 5 out of 10.

 

Overall

4 out of 10 as a simple average. This is a slightly higher score than Bengen which seems appropriate given that, unlike Bengen, the constant percentage at least ensures that retirees do not run out of money in the later years of retirement. 

 

So what next?

Next week, Tim will be looking at a range of ‘advanced withdrawal methods’ 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;

Drawdown Diaries Webinar