In his latest diary entry, Tim Jablonski, EValue Product Director discusses ‘Advanced Withdrawal Strategies’ that combine a number of different withdrawal methods that he has introduced over the last few weeks.
This week, Tim explores the following withdrawal methods;
- Cap and Collar Adjustment Strategy
- Ratcheting Strategy
- Guyton-Klinger Rules
Watch Tim’s latest video diary entry now:
Cap & Collar Adjustment Strategy
The Cap & Collar Adjustment strategy applies restrictions on the size of the inflationary increase (or decrease) to apply to the withdrawal each year.
Whereas Bengen’s rule states that you should adjust for inflation in any economic environment - both in periods of high inflation and deflation - the cap restricts those inflationary increases.
For example, a 5% cap and a zero collar mean that: in periods of high inflation, the withdrawal will not increase by more than 5% in any one year; and in periods of deflation, the withdrawal will remain level.
By adopting this approach, it’s likely that your money will last longer - since it’s more likely that there’ll be more periods of high inflation than deflation, so lower-income to be withdrawn in the future - on average. But in those periods of high inflation, your income is not keeping pace with inflation, which - depending on your circumstances - could be problematic!
Scores on the doors
Simplicity - Very simple - only slightly less straightforward than the Bengen 4% rule. 8 out of 10.
Flexibility - Low: the spending is fixed each year so doesn’t allow for one-off requirements; although it keeps pace with inflation when it falls between the collar and cap, it could fall behind in periods of high inflation. 1 out of 10.
Durability - Some effort has been made to make money last longer by capping the inflationary increases, but there is no action taken relating to investment performance other than that. 3 out of 10.
How easy is it to manage - Just as easy to manage as Bengen’s 4% rule. However, if you want to deviate from the 4% starting point and set your withdrawal rate, that can be far more difficult, as can determine the values of the cap and the collar to apply. 5 out of 10.
Cost - Perhaps an adviser would be required to set the starting withdrawal rate and the cap and collar. Once that has been established, the ongoing management of the strategy need not require an adviser or modelling tools. 6 out of 10.
Investment performance - Little is said about the investment strategy, and the application of the cap and collar seems unrelated to the investment strategy, which makes this hard to score. I suppose, since no attempt is made to determine a good strategy, it must be scored low. 1 out of 10.
Introduced in 2015 by American financial planning expert Michael Kitces, The Ratcheting Safe Withdrawal Rate: A More Dominant Version of the 4% Rule? hints that Bengen’s 4% rule could be underplaying the amount of money a client can safely withdraw from their pension pot. The rationale behind this is that Bengen’s theory is based on the worst possible sequence of historical data, and therefore does not take into account many positive market scenarios that could offer returns that could safely accommodate a higher withdrawal rate.
So he proposes a simple ratchet-style strategy.
The strategy begins in line with the 4% rule. So 4% as the starting point, increasing in line with inflation each year - but if the portfolio rises to more than 50% above its starting value, then the withdrawal is increased by an extra 10%.
To avoid ‘ratcheting’ the withdrawal rate up too high too quickly, the 10% increase cannot be applied more than once within three years.
According to his modelling, Kitces discovered that compared to the traditional 4% rule, a ratchet-style approach offers a better overall withdrawal rate across the majority of market scenarios, including those where a client would typically require to lower their rate of withdrawals in the event of a market downturn.
Although this strategy addresses the concern that retirees may under spend in retirement, it does not address the reverse concern that 4% could be an unsustainable level of income. It does not build in any flexibility to reduce the level of income where it might need reducing in extreme market conditions. Indeed, many of the failings found in Bengen’s 4% rule apply in this ratcheting approach, including the core failing of the underlying modelling. We discussed these drawbacks in our previous blog, The Drawdown Diaries: Episode 2 - Bengen’s 4% rule.
Scores on the doors
Simplicity - Simple - a single rule on when to apply a further increase, complicated marginally by having it apply at most every three years, but still straightforward. 7.5 out of 10.
Flexibility - Flexibility to increase withdrawals, but not to reduce, and only on the prescribed term. 3 out of 10.
Durability - Similar in durability to Bengen’s 4% rule, though slightly less durable because of the increases. 2 out of 10.
How easy is it to manage - The 4% starting withdrawal rate is a smooth start. Assuming you apply the rules as they are, and determine not to use the increases more frequently than every three years, then it is reasonably easy to manage - you need to track your pot size, inflation and the previous year’s income. 7.5 out of 10.
Cost - As with the 4% rule, this doesn’t 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 - Alas, it has the same failings as we identified in our blog article on Bengen’s 4% rule. 1 out of 10.
The Guyton-Klinger rules can be seen as a mixture of both the simpler ‘constant-withdrawal’ and ‘constant-percentage’ methods. It is like a constant amount withdrawal strategy with constant percentage checks in place.
In this strategy, we select an initial withdrawal amount, say 4%, as in our previous examples. With an initial pension pot of £1,000,000, an annual withdrawal of £40,000 would be made, which we would plan to increase in line with inflation each year. However, the first difference is that the inflationary increase only applies when there has been a positive return on the retirement pot.
Next, we set “guardrails” around this percentage, which indicate when to take action. The guardrails would typically be set to 20% above and below the base withdrawal rate - so at 4.8% and 3.2% in our example.
Each year, the amount to be withdrawn - increases in line with inflation for years in which the return had been positive - would be compared to the overall retirement pot size; if the withdrawal amount is more than 4.8% of the pot, the withdrawal is reduced by 10%; if the withdrawal amount is less than 3.2% of the pot, then it is increased by 10%.
These guardrails - and the accompanying increase and reduction to withdrawals - need not apply in the final 15 years of retirement.
There is a further Guyton-Klinger rule, which describes how to withdraw funds from the portfolios. It seems like an overly-complicated description of something very similar to re-balancing but making use of a cash account to store some excess gains temporarily. We won’t go into any further detail on this now, although its complexity must surely be taken into account in our scoring.
This approach looks to address the issue of sequencing risk by reducing the amount of income withdrawn in the bad years, which is a definite improvement to Bengen’s 4% rule. And by applying extra withdrawals when the portfolio has increased significantly, it also addresses the risk that the retiree under-spends throughout their retirement.
Although this additional flexibility is welcome, it is applied in a particularly inflexible way. If the market suffers a significant downturn, then the retiree should perhaps consider withdrawing as little as possible, rather than merely reduce their withdrawal by 10%. Also, although the removal of the guardrails in the final 15 years of retirement is a sensible move as the retiree draws down their capital, it is not easy to determine when that 15-year period should start, nor what you should do in extreme market conditions within those 15 years.
Scores on the doors
Simplicity - Lots of rules combined make this hard to explain and follow for many. 2 out of 10
Flexibility - No real flexibility since the withdrawals are prescriptive - even if there’s a degree of built-in flexibility within the rules themselves. 4 out of 10
Durability - More effort has been made here to address the level of income taken, to ensure that the money lasts longer. 6 out of 10
How easy is it to manage - This is harder to manage. The 4% level is not assumed, so you need to set your withdrawal rate to start. You can take and apply the default 20% guardrail with 10% changes to withdrawal, which is a little fiddly, but not too complicated. It would help if you determined when to stop applying the guardrails, for which care needs to be taken. And it would be best if you managed the cash buffer. Many parts that add up to something very complicated. 2 out of 10.
Cost - Adopting this approach will require a financial adviser so there is a higher cost but outcomes could be a lot better. 5 out of 10.
Investment performance - This strategy proposes a particular portfolio management approach: broadly speaking, this is a re-balancing, plus use of a cash buffer to deal with excess gains. Re-balancing seems sensible, but its prescriptive use seems a complicated hindrance, and the cash buffer looks unhelpful and unnecessary here. 5 out of 10.
Bringing this all together
Overall, scoring should be based on a combination of the average scores above and on how previous strategies have been scored - where adjustments to those scores have been deemed necessary.
Cap & Collar
Compared to the 4% rule, this strategy reduces the likelihood of running out of money but also reduces the level of income withdrawn. Since the shape of income in retirement is seen to decrease in real terms, the positive gain here might marginally outweigh the loss. As such, it should be scored slightly higher than the 4% rule. 3.5 out of 10.
Like Bengen’s 4% rule, the simplicity raised the average result for the ratcheting strategy. However, it is unclear how a higher score than the one given to Bengen can be justified, particularly as the chances of running out of money are increased. A generous score would be to balance the potential for a higher income with the increased risk of running out of money and award the same score as for Bergen, i.e. 3 out of 10.
The scoring for this strategy depends significantly on whether it is to be administered by an adviser. This is the most complex strategy, which would undoubtedly require an adviser. In our scoring table above, this marks it down on cost (but with the potential immeasurable upside resulting from advice), simplicity and ease of management. It seems unfair that this should multiply the negative point in this way, so we increase it to 6 out of 10.
So what next?
Next week, Tim will be looking at strategies that apply a natural income withdrawal strategy, and will discuss whether holding a cash reserve could benefit your clients.
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;