Drawn Down Pension Questions

Lismac

i am confused as to how a draw down pension works. Say if I were to have £1M in a pension pot and I chose a drawn down pension rather than an annuity, everywhere I read it advises to base this on an annual income of 4% which I understand. I would think that the 4% a year would mainly be interest, I know there is no guarantee as pots go up as well as down but generally the interest on my pensions the last couple of years seems to be running at about 6% so let's say for arguments sake that the 4% you take is mainly just interest. Are you able to then take a further say £30K a year of the actual overall £1M and then the next year only have £970K in pension? And you could continue that for say 10 years until your state pension kicked in for example or your costs reduced. I realise that compound interest would also be lower on the £970K and the £40K interest would reduce, but in theory is this how they could work? I have never gotten the answer to this in all my searching....

jimi_man

To keep it in very simple terms, there are two calculations. One is how much you take out - the drawdown, and the other is how much you put in - the 'interest' (for want of a better word).

So in your example, £1,000,000 is the starting value. You take 4% which is £40,000. You now have £960,000. Then if the 'interest' is 5% (for example) you add £48,000 to your pot which makes it £1,008,000. And then the same again next year ..... ad nauseam. 

As you can see, the variables here are how much you drawdown each year and the 'interest' each year. You can take as much as you like (bearing in mind the tax thresholds) but obviously your money won't last as long. Also if the 'interest rates' are lower (I'm talking stock market performance here) then not as much money will be added. There should be a sweet spot of money out and money in (and in general it's likely to be less than 4% withdrawal but that's another thread) whereby your pot will sustain itself.

So don't think in terms of taking 'just the interest', think in simple terms of a pot of money that is affected by those two calculations. 

Albermarle

The 4% you have read about is a theoretical 'Safe Withdrawal Rate ' . It is based on historical statistics regarding performance of investments through many up and down cycles in the markets. ( some say 3.5% is better ) The idea is that if you take 4% rising with inflation each year , then there is only say a 5% chance of the pot running out in 30 years , even taking into account a few market slumps in that period. If you say increase the rate to 5% then you will probably still be OK but the chance of running out will increase.

An alternative is to increase the withdrawal rate when market returns are good, and reduce it during lean years.

Another alternative is as you suggest , to take more in the early years and less later , when other sources of income kick in .

One issue to look out for is 'Sequence of Returns Risk '. You can google the details but basically if markets slump at the start of the drawdown it has a magnified effect compared to it happening later.

dunstonh

everywhere I read it advises to base this on an annual income of 4% which I understand. 

That is wrong.    The draw rate should be no more than you need unless there is other justification.   A draw rate of 4% is above the level considered sustainable for the UK.   For the UK, 3.5% is considered more appropriate but less if you are in your 50s.

 I would think that the 4% a year would mainly be interest

Where can you get 4% interest?

I know there is no guarantee as pots go up as well as down but generally the interest on my pensions the last couple of years seems to be running at about 6%

I doubt that is the case.  Are you referring to your total return as interest?  if so, it is not interest.

Are you able to then take a further say £30K a year of the actual overall £1M and then the next year only have £970K in pension?

yes. You could take the whole £1m if you wanted.

And you could continue that for say 10 years until your state pension kicked in for example or your costs reduced.

yes

I realise that compound interest would also be lower on the £970K and the £40K interest would reduce, but in theory is this how they could work? 

Ignoring the incorrect reference to interest again, yes.  You have the value of your pension and you can draw against the value when you like, how you like and how much you like.   

Values will zig zag daily through market movement but a £30k withdrawal will lower your value by £30,000.

Lismac

jimi_man said:

To keep it in very simple terms, there are two calculations. One is how much you take out - the drawdown, and the other is how much you put in - the 'interest' (for want of a better word).

So in your example, £1,000,000 is the starting value. You take 4% which is £40,000. You now have £960,000. Then if the 'interest' is 5% (for example) you add £48,000 to your pot which makes it £1,008,000. And then the same again next year ..... ad nauseam. 

As you can see, the variables here are how much you drawdown each year and the 'interest' each year. You can take as much as you like (bearing in mind the tax thresholds) but obviously your money won't last as long. Also if the 'interest rates' are lower (I'm talking stock market performance here) then not as much money will be added. There should be a sweet spot of money out and money in (and in general it's likely to be less than 4% withdrawal but that's another thread) whereby your pot will sustain itself.

So don't think in terms of taking 'just the interest', think in simple terms of a pot of money that is affected by those two calculations. 

Thank you so much for such a concise, non patronising answer, very helpful

Lismac

I understand the concern about running out of the pot, but I also don't want to end up with a pot at 95 years of age and no means of spending it when I could have had a much easier lifestyle at 65-75 when I was able to enjoy it more.

NedS

Lismac said:

I understand the concern about running out of the pot, but I also don't want to end up with a pot at 95 years of age and no means of spending it when I could have had a much easier lifestyle at 65-75 when I was able to enjoy it more.

And that, my friend, is the issue we will all be grappling with - to which there is no easy answer without the benefits of a crystal ball. Best you can do is to reevaluate your position every year and to adjust your spending if necessary.

Thrugelmir

Lismac said:

I understand the concern about running out of the pot, but I also don't want to end up with a pot at 95 years of age and no means of spending it when I could have had a much easier lifestyle at 65-75 when I was able to enjoy it more.

Perhaps annuitising part of the pension pot would be a better option then. Rather than riding the roller coaster of global investment markets. 

Albermarle

Lismac said:

I understand the concern about running out of the pot, but I also don't want to end up with a pot at 95 years of age and no means of spending it when I could have had a much easier lifestyle at 65-75 when I was able to enjoy it more.

That is entirely your decision but for many people , the prospect of running out of money late in life scares them . Also you will still be able to easily spend money at 95.You might not be spending a lot on wine, women and song at 95 , but being able to pay for things that made your life more comfortable ( or even just things like a new washing machine etc ) would probably be helpful . 

Moonwolf

For what it is worth you can also mix and match.  You could spend some until other pensions kick in, say £100,000 then get an annuity with £200,000 then do safe drawdown from the £700k left.  If you have a property and like me are not worried about passing it on then the value of your property is also protection, you could use equity release.

I have two budgets, one is my basic no too uncomfortable.  That is about £25K a year (after tax) for me and I expect to use a mix of state and defined benefits to cover that but if I had just a pot I would probably put some into an annuity (and this might still happen).  I will try and always have at least this.

My second is my very comfortable living which is about £32K a year (after tax).  I intend to spend to that and will probably run out in my 80s and then have to live on the £25k. (My spreadsheet assumes cash reduces by value at 1% a year and investments grow by 2.5% over inflation. These could be well under or well over I don't have a crystal ball.  If I run out early I will have to live on £25k a year.

I have budgeted top down looking at what I earn and spend now and taking off work expenses and bottom up allowing for a new car every three years and national trust membership and so on. Very comfortable has lots of holidays.  However at 85 I probably won't want all those holidays and might be going out less, scrap the car and just Uber, who knows?  This might mean I will draw down less, I haven't assumed it but it works.

If I reach 90 and have run out but need a care home then I'll use equity release from my property.

All this is a bit simplistic and there is my partners stuff and future added into the equation.

gm0

The first thing which you have already started on is "will my pot last the required time - from retirement to probable demise - 30 years, 40 years etc.) at the income level I "need" or the income level I "want".  Allowing for things like State Pension(s).

The 2nd issue to get a grip on - How should my plan look to guard against "bad" sequence of returns (actions to make you sleep easier about this are likely to be at the expense of long term "potential" growth and pots left for heirs)

The key to grasping this set of choices is first getting the ugly arithmetic of sequence of returns straight.  None of the analysis about "on average" outcomes is helpful after the fact to the specific one thing that happens to you.  The fact that on average people died with larger pots is of little comfort if you were among the few who ran out.

A spreadsheet makes it very easy but a pen and paper will do the job. 

Draw up something like this and play with the "size" of the correction and recovery and the income level.  This example has 3 rows of returns - all of which are the same long term average 3% but which deliver different pot sizes at year 10 (25% of the way through a long 40 year retirement).   "Early negative" sequence person has fallen behind by a couple of years income.  And that sets the start value for the "next" 10 years. If there is another bad sequence - they will likely run out ahead of plan - and significantly ahead of the "flat" returns or "early positive" person.

Returns	Early negative	0	-15	-8	12	6	8	6	8	5	8
	Flat	3	3	3	3	3	3	3	3	3	3
	Positive first	3	3	8	8	2	6	12	-4	-10	2
Start	300
		288	233	201	213	213	216	216	219	216	219	205
		297	294	290	286	282	277	272	266	260	253	239
		297	294	305	316	310	315	339	312	267	258	243
	4% Income	-12	-12	-12	-13	-13	-13	-14	-14	-14	-14	-15

Income shown indexed at 2%.


You cannot control sequence of return nor predict it accurately.  But you can take steps to mitigate the impact of it on your plan.  

These include topics such as:

- Cash buffers to support income for a few years -ve sequences

- A variable rather than a fixed and inflation indexed income (hence the need to consider "need" and "want" separately

- Asset mix - diversification and setting of overall risk level

- Consideration of the current situation in terms of markets, inflation, government action as a guide to what is more or less "probable" and whether that should affect what you invest in / cash held.

- Variable income methods (draw less during negative sequences)

- Other contingencies related to living arrangements, property etc.

- Care cost and spending assumptions about extreme old age


If you start to look at web material on drawdown and backtesting (use of past market returns to assess it) then remember this. 

The past does not predict the future.  But a plan that would have failed to work a fair amount of the time in the past is rather *unlikely* to work in the future either.  It would be a triumph of hope over experience to just roll the dice on it and hope for the best.