How never to run out of money in retirement

The ‘4pc rule’ on pension withdrawals can be broken with the right investments

Ed Monk

If there’s a superstar in the world of retirement planning, it’s William Bengen. His “4pc rule” has helped countless people avoid running out of money in retirement.

Mr Bengen, an American financial planner, conducted a detailed analysis of a huge number of hypothetical retirement scenarios in a range of economic circumstances to arrive at his rule.

He found that even investors who retired at the worst possible time would be able to fund a 30-year retirement if they limited withdrawals to 4pc of their savings in the first year of retirement and increased them in line with inflation thereafter.

Some would be able to withdraw more each year, fund a retirement longer than 30 years or even leave at death a large sum to pass on to their children.

In the three decades since he published his original research, Mr Bengen has continued to refine his rule as further data was released, enabling him to improve his analysis. Much like Mr Bengen, those applying his rule should keep an eye on the markets and inflation to ensure their plan remains sustainable.

Here, Telegraph Money explains how to use it:

How much of your pension fund can you safely withdraw?

The rule is simple: if a retiree were to withdraw 4pc of their pension pot in the first year of their retirement and then increase withdrawals by the annual rate of inflation, their pension pot would last them no less than 30 years.

He modelled his rule from 1926 onwards, meaning that even accounting for “worst case scenarios”, such as the Wall Street Crash and Great Depression, the pot would not run out.

But with a further 31 years of refinement, Mr Bengen has discovered that savers can afford to increase their withdrawals if they plan appropriately.

His research relates to American investors, but the broad principles also should apply to the UK.

It states that if a pension pot is invested 50-50 between large-cap US stocks and US Treasuries, a saver can draw down their pot starting at 4pc. However, if they add a broader range of assets, including international stocks and smaller US companies, they can safely increase their withdrawals to 4.7pc of the initial pension pot.

pension drawdown

How to manage falling markets

If you do plan to fund retirement from a pot of money invested partly in shares, your biggest fear may be a bear market. After all, pension providers allow you to look up the value of your pot every day, and in a bear market, that value will be falling, perhaps dramatically. In those circumstances, it may well feel reckless not only to maintain your withdrawals at a predetermined rate, but to increase them every year in line with inflation.

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But when Mr Bengen looked at the figures, he found that the tendency of markets to recover was enough to prevent permanent damage to retirement income from a bear market in the early years of retirement, even at initial withdrawal rates as high as 7.2pc.

In a research paper commissioned by Fidelity International, he said: “Although bear markets can have painful effects on portfolios in the short term, they are usually followed by recoveries, which enable the portfolio to regain its former value and then some.

“The lesson here is that in the event of a ‘normal’ bear market in stocks, taking no action [i.e. maintaining withdrawals in line with the plan] might be the best strategy.”

He did, however, warn that this reassuring conclusion might not apply to particularly severe bear markets.

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How to manage inflation

Rather than bear markets, what retired investors should really fear is a severe or prolonged bout of inflation, Mr Bengen said. When he modelled the effects of such an inflationary period – specifically, 4.6pc in the first year of retirement and rising to 10.2pc in the seventh year, before a slow decline – for a saver who started with a withdrawal rate of 5.5pc, he found that the saver could not afford to just carry on with the planned withdrawals.

Doing that would result in the withdrawals quickly becoming unsustainable, putting the saver on course to run out of money well before 30 years had passed. In this scenario, what Mr Bengen called a “draconian” 28pc cut in withdrawals in the sixth year would be required to restore the plan’s sustainability.

He added: “How many of us could contemplate a 28pc reduction in withdrawals from our retirement accounts in mid-retirement?

“For many, it would be a severe blow. And, even given this harsh reduction, we can’t be sure it will be sufficient if inflation persists at a high level.

“This underscores the observation that inflation is the greatest threat to the lifestyles of retirees.”

We should emphasise that if the saver had instead stuck to the original 4pc rule and not opted for first-year withdrawals of 5.5pc, all would have been well.

Mr Bengen concluded: “A retirement withdrawal plan requires active management. Adjustments may have to be made during retirement, although not all deviations from the plan require immediate action.

“Bear markets come and go, and many can be safely ignored. However, high, sustained inflation may be the justification for panic.”

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When to reduce withdrawal rates

Mr Bengen’s method for reassessing withdrawal rates might require a moment to understand but is simple in principle.

It involves the calculation at the start of retirement of what each year’s withdrawals will be as a percentage of the theoretical value of the pot each year, assuming steady inflation and investment growth at historically average rates.

You then compare, as retirement progresses, that hypothetical withdrawal rate with the actual one. The actual figure, calculated each year, is your actual withdrawal, in pounds, divided by the actual value of the pot at the beginning of that year.

The two withdrawal rates – the hypothetical and the actual – are bound to differ because variations in inflation will affect the amount you withdraw each year, while the value of the pot will, in practice, fluctuate from year to year in line with the financial markets.

It is this difference between the hypothetical and the actual withdrawal rates that you need to pay attention to. Small, brief gaps are nothing to worry about, but a wide and prolonged gap is a sign that withdrawals may be unsustainable.

Ed Monk is an investment writer at Fidelity International. Mr Bengen’s new book, A Richer Retirement: Supercharging the 4pc Rule to Spend More and Enjoy More, analyses more withdrawal scenarios.