Ripping up the retirement planning handbook – Part 4

Planning on using a drawdown strategy for your pension? How should your pension fund be invested? And how do you avoid running out of money? Recent academic studies in the US may hold some interesting answers…

For many people, the default option (often known as the ‘lifestyle option’) in money purchase pension schemes makes sense. A lifestyle fund invests in a diversified portfolio of assets such as fixed interest bonds, property and equities which reduces the equity exposure as you get closer to retirement. However, if you’ve got more to play with and are considering flexible drawdown, this might not be the best choice.

It’s not straightforward. In the US, academic research has looked at the impact of flexible drawdown. The main recommendations are that drawdown needs to maintain a healthy allocation to high risk growth assets such as equities to support the longevity of the portfolio.

That means maintaining your exposure to equities instead of decreasing it the closer you get to retirement. You may need to ring fence your tax free cash allocation into lower risk assets as you close in on retirement, but the US academics generally agree that a successful drawdown strategy needs equity exposure to make it last through your lifetime.

There are then two further questions: what’s a sensible amount to draw annually, and what’s the best asset allocation between equities and bonds, to support your withdrawal rate? In the US, the ‘safe withdrawal rate’ of an annual income (adjusted for inflation each year) has been estimated at 4% per annum from a 60/40 balanced portfolio (60% equities and 40% bonds) over a typical retirement period of 30 years. This analysis is based on rolling periods of portfolio performance from 1926 onwards. Although 4% per annum is a useful metric, further analysis shows a portfolio could still risk of running out of money, particularly as portfolio returns vary over time.

Our take on the UK picture

Our own analysis suggests a 60/40 UK portfolio with a 4% per annum, inflation adjusted withdrawal rate has a 25% chance of running out of money.

However, a portfolio’s longevity can be improved by applying what we call a ‘dynamic withdrawal rate’ – reducing the income withdrawal rate when the portfolio falls below a certain targeted level. This adjustment results in only a 3% failure rate over the same 30 year period. Equally, you may not be aiming to have too much surplus pension left after death.

Overall, a successful drawdown strategy for retirement requires expert hands–on management, including the ability to model pension fund returns and withdrawal rates in line with fluctuations in returns (what we call Monte Carlo analysis).

Finally, remember your pension fund makes up only part of your overall wealth. Outside of your pension, you may have other savings to develop an income such as investment funds and ISAs. And, of course, you might consider releasing cash from your home, by downsizing later in life. In addition, with the new level of ‘super tax efficiency’ for pension funds on death (they are outside of your estate for inheritance tax – see Part 3, September 2015), developing an income in retirement should also address whether you spend part of your personal wealth. This will reduce your inheritance tax liability while leaving more of your pension fund to the children – free of inheritance tax.

Jonathan’s action plan: While the new drawdown rules bring increased flexibility and accessibility to funds, we believe careful financial planning and portfolio management are still needed for a happy and healthy financial retirement.

Want further advice? Email Jonathan Elsigood at jonathane@cooperparry.com