Drawdown: safe withdrawal rates

This is for things about the philosophy of the subject, notably the different approaches that people prefer. Traditionally the division is between safety-first and probability-based approaches. A person with a strong safety first inclination might choose to take a lower likely income from using cash or buying annuities while a probability oriented person would prefer the higher income generally available that way unless the worst cases happen. Whichever approach is used some certain income is useful, in the UK that's usually most cheaply bought around normal retirement ages by deferring the state pension. Don't disregard guaranteed income even if you're happy to be invested, a suitable amount increases the safe withdrawal rate.

The Yin and Yang of retirement income philosophies and the more extensive PDF version. Discusses the key differences in philosophy.
Even Safety-First Retirement Income Strategies Are Probability-Based - The Real Distinction Is Risk Transfer Vs Risk Retention

Non-essential interesting material

• Guyton and Kitces with Continued Discussions on Safe Withdrawal Rates and Spending Decision Rules, videos that provide some easy enough to follow introduction to a range of issues.
• Year 2000 had the highest 10 year cyclically adjusted price/earnings ratio ever. How Are People Who Retired In The Year 2000 Doing Today? (replaced broken link) On track is the answer. But also see Guyton's sequence of return risk taming that would have reduced equity holdings substantially, helping them!

Various drawdown rules that people can use, personally I like a modified Guyton and Klinger approach. Bengen's original 4% rule is no longer very good even though it was revolutionary at the time, later ones can do a better job.

• Decision Rules and Maximum Initial Withdrawal Rates Guyton and Klinger's decision rules paper. See Drawdown rules help for a simple summary of the rules and discussion of how to use them. The UK 90% success rate safe withdrawal rate using the Guyton-Klinger rules is initially 5.5%.
• Determining Withdrawal Rates using Historical Data Bill Bengen's original 1994 4% rule paper. Later observations about 4.5% rule and that 96% of the historic cases would produce a higher nominal ending pot than the starting one, while two thirds of the time the ending wealth is at least twice the starting wealth. Summary and links to his interesting later papers and the importance of small cap equities, Small-Cap Withdrawal Magic. 4.5% used 35% large cap, 20% small cap and 45% intermediate duration bonds. In 2017 he wrote "longer time horizons require higher equity exposure than the 30-year time horizon. For 45 years, I calculated 65% equity exposure as optimal, with a 4.1% SWR".
• What Returns Are Safe Withdrawal Rates REALLY Based Upon? Michael Kitces explains.
• Making Sense Out of Variable Spending Strategies for Retirees Wade Pfau looks at a wide range of spending strategies in a Journal of Financial Planning article, an excellent overview of the range.
• New Math for Retirees and the 4% Withdrawal Rule New York Times interview with Bill Bengen about his 4% rule and others.

If using US data and UK investments, subtract 0.3 from the safe withdrawal rate percentage, roughly the expected difference between US and UK SWRs; more detail on UK SWRs here, which mentions a UK SWR of 5.5% using Guyton-Klinger over 40 years with 65% equities; both also discuss Guyton-Klinger. The UK worst case is a 1936 start.

Improving the rules

• Hold a year of investment income in cash. Though see Cash reserve buffers, withdrawal rates and old wives' fables for retirement portfolios for some things not to do, the cash should replace some bonds, not equities. Though none of the scenarios he modelled seems to have been cash replenished by interest and dividends mainly.
• Use equity release that allows drawing and repaying to smooth income, allows higher income, see The New Case for Reverse Mortgages and Academic Acceptance for Reverse Mortgages in Retirement Income by Pfau and notice that in a low interest rate environment it can potentially double the safe withdrawal rate! The improvement is better from early use than last resort use.
• Blanchett's Estimating the True Cost of Retirement that shows spending declines until age 75 in the US and throughout retirement in the UK, particularly at 80+ and even faster for high spending households than low. Typical is a 35% drop from 65 to 80 initially. Plan to start at an unsustainably high income and decrease.
• Does Asset Allocation Affect Withdrawal Rates? : yes, more equities increase the upside without affecting the downside much, while long term bond allocations above 50% do serious harm, though do use them for Guyton's sequence of return risk reduction method.

How much do I need to pay in each month to get to a particular income level at a target age?

These are some very rough numbers for those far from the planned ages, anyone within ten years needs to use more fancy methods.

Split the desired amount into two time periods, first from after state pension age, then for the time before state pension age. I'll use age 40 now, age 55 target and 18k income target as an example.

1. From state pension age of say 68 part, deduct your expected state pension amount, say 8,000 if you don't know it, from your target annual income. Multiply the remaining target by 25 to get the 4% rule estimated pension pot size requirement, £10,000 * 25 = £250,000. To start enter 100 monthly gross, 28 years duration (68-40 years old), 4.5% interest rate (long term UK stock market performance less about 0.5% for costs). That'll say that each £100 a month gets you £67,123 pension pot. Adjust the monthly amount to get to the 250k needed and you'll find it's £373 gross a month. [NOTE: this 28 year duration assumes that you'll be paying in £373 gross a month even after you have retired at 55! So you'd need to budget for that in your income plan and I haven't done that in step 2 in this example]

2. For the part before the state pension you'll need to cover the whole income target yourself. But it doesn't have to last for life so you can draw more. As a very rough way to allow for this multiply the income required by the number of years between retirement age and state pension age. So £18,000 target x (68-55) = £234,000. Back to the regular savings calculator, duration 15 years (age 55 - age 40), interest rate 4.5% and adjust the monthly payment until you get to the £234,000 required. Answer is £913. Notice how much higher it is than the after state pension number with more growth time available.

Now add the two numbers and you have your monthly gross pension contribution target of £373 + £913 = £1,286 a month.

Too much? Check the effect of a five year delay to age 60. Target £18,000 x (68-60) = £144,000. Now duration of 20 years (age 60 - age 40) and the regular savings calculator says £371 a month before state pension age and a total amount of £373 + £371 = £744 a month. Much easier.

What if you're on minimum wage? £14,976 a year for 52 40 hour weeks in 2016. If you need 80% of this in retirement that's a target of £11,980.80 a year. £8,000 comes from the state pension leaving you £3980.80 a year to fund. At assumed age 68 state pension age and starting from age 30 you'll need a pension pot of £99,520 which would take gross £82.75 a month. Using 2018 auto-enrolment rates a total of 8% of qualifying pay is required, 3% from employer, 1% from tax relief and 4% from you. That would potentially halve your net cost to £41.38 a month. In 2016/17 the lower level of qualifying earnings is £5,824 a year so if you are on £14,976 your employer would have to pay in only on £14,976 - £5,824 = £9,152. 8% of £9,152 is £61.01 gross a month, vs your higher £82.75 a month target so your employer isn't required to pay in for the full amount. They can choose to use your whole £14,976 pay and if they did that the 8% would be above your target at £99.84 a month. If you used only the £61.01 gross then your anticipated pension pot size would be £73,395 and that could produce an income of £2,935 a year, taking your total including state pension to £10,935.80 which is 73% of your gross pay. But your take home pay on £14,976 would be £13,350.88 and it's 82% of that if it's all free of income tax, which it probably will be. Not at all bad since you'll have no work-related costs when retired.

Various investment strategies and methods.

Pension contributions

Continue to make pension contributions from age 55 until reaching age 75 unless lifetime allowance or something else makes it a bad idea. There is free money to be had.

At basic rate income tax with all personal allowance used: Pay in £2,880, take out 25% tax free, £900, take out £2,700 taxed at 20% net, £2,160. Net gain £900 + £2,160 - £2,880 = £180

With at least £2,700 of personal allowance still unused: Pay in £2,880, take out 25% tax free, £900, take out £2,700 nil tax due, £2,700, £2,700. Net gain £900 + £2,700 - £2,880 = £720

If you flexibly (UFPLS or drawdown) take out anything beyond the 25% tax free lump sum from a personal pension you will have the amount you and anyone else can pay into defined contribution pensions in your name reduced to £4,000 a year by the Money Purchase Annual Allowance (MPAA). Usually this won't matter but it may if you're continuing to work. It doesn't affect contributions to defined benefit pensions like final or average salary.

You can take all of the money out of up to three personal pension pots per lifetime each worth no more than £10,000 using the small pots rule without triggering the MPAA reduction. This is described at PTM063700 and can be either money you've taken a tax free PCLS from already (so all taxable) or uncrystallised (25% tax free).

Taking taxable money from the state pension or a defined benefit pension (like final or average salary) doesn't trigger the MPAA 4k restriction. It isn't triggered if you have one of the older pre-April 2015 capped drawdown products and only draw up to the GAD limit.

The limit on what you can pay in and get tax relief on is your earned (technically, qualifying) income or if lower, £2,880 net, £3,600 gross.

There's extensive discussion of this at Paying £2880 into pension when retired.

State pension deferral

Defer your state pension if you have normal life expectancy and no special case for not doing it. Up to five years has a good chance of breaking even, up to ten years can be good for longevity insurance (more here) and to increase the safe withdrawal amount from drawdown, by providing more of your minimum income requirement, see for example Blanchett's paper The Impact of Guaranteed Income and Dynamic Withdrawals on Safe Initial Withdrawal Rates.

A person who reached state pension age after 6 April 2016 gets an increase of 5.8% per year of deferral, pro-rated for parts of years, not inheritable, no lump sum option. Before then the increase is 10.4%, mostly inheritable by a spouse and with the option of taking a lump sum that is taxed at your current highest income tax rate, which could be zero if within your personal allowance. For deferral before 6 April 2005 the increase was 7.5% with no lump sum increase and a cap of five years.

For how long to defer see Does it pay to delay your state pension? and use the calculator at https://www.johnkay.com/pension/ that is unusual because it takes the alternative investments into account. Use the end of your planning horizon or longer as your remaining life expectancy when using the calculator for drawdown planning.

I get these break even numbers of years to defer using normal life expectancy:

If invested to get 3% plus inflation (shares, corporate bonds)
Male aged 72, 15 years to go, defer 1 year 5 months
Female aged 67, 22 years to go, defer 4 years 2 months

If using savings accounts to get 0% plus inflation
Male aged 72, 15 years to go, defer 2 years 8 months
Female aged 67, 22 years to go, defer 6 years 2 months

I get these break even numbers of years to defer using the life expectancy that one person in four will reach:

If invested to get 3% plus inflation (shares, corporate bonds)
Male aged 72, 21 years to go, defer 3 years 9 months
Female aged 67, 29 years to go, defer 6 years 7 months

If using savings accounts to get 0% plus inflation
Male aged 72, 21 years to go, defer 5 years 8 months
Female aged 67, 29 years to go, defer 9 years 8 months

For more background see:
Deferring a state pension - is it worthwhile? (Caution, this does not use cohort life expectancies and doesn't compare to other uses of the money. Use the two or five year above average results to try to compensate).

What is state pension deferral?, handy for abroad tip. SPA effects if abroad (7.20 on):

• before 6 April 2016: get deferral increases anywhere, can't start while abroad after having claimed
• from 6 April 2016: don't get deferral increases without a reciprocal arrangement (80% affected are in Canada, NZ, Australia), can start while abroad

State pension inheritance rules.

Class 3A state pension top-up: archived, ended 6 April 2017.


The limits on recycling pension commencement lump sums, the usual tax free lump sums

If worried about lump sum recycling remember the threshold of £7,500 that has to be exceeded within a 12 month period and that as of 2015 HMRC is believed never yet to have invoked the rule for an individual because it is intended to block organised schemes (also see this post) and it is not a focus of their efforts. For much more discussion see Can husband give his 25% tax free sum to me to reinvest in my pension pot?.

If any of these are true it is definitely fine:

1. The total amount of all tax free lump sums taken in a twelve month rolling period (not tax or calendar year) is no higher than £7,500.
2. You didn't plan to recycle when you took the tax free lump sum. HMRC has to prove that you did, not you prove that you didn't. This would catch out people using organised schemes.
3. The timing of the lump sum(s) coincided with routine things like retiring or reaching the normal retirement age of a defined benefit pension.

If none of those apply, add up the total amount of pension contributions you make in the year of taking each lump sum, the two tax years before that and the two tax years after that. Divide by five and compare to your typical amount of pension contributions.

A. If the average is not more than 30% above what it was before it's fine: "a significant increase does not occur unless, because of a pension commencement lump sum, the amount of the additional contributions are more than 30% of the contributions that might otherwise have been expected".
B. Subtract the average of those five years from the previous average and multiply by five. If this is less than 30% of the value of the lump sums it's fine.

HMRC might disagree about working out the value of the increase. Also many increases are fine, like increases due to inheritance, pay rises, following changes in income tax thresholds and many other things including normal retirement planning. You can subtract the increases from those things when working out the increase in the calculations. You might also be taking the tax free lump sum as soon as you can just to get it in case of a change of rules later, as a result of the constant talk that the tax free lump sum possibility might go away - that's my own intention - then you have to do something with the money.

The limits apply to pension contributions in your own name. You can take a tax free lump sum into a bank account in your own name and give it to a spouse or anyone else and they can make pension contributions in their own name from their own bank account or via a work scheme without anything other than the usual contribution limits. Though if it's clear that you are arranging mutual gifts that could be taken to break the rules as a sham arrangement.