Withdrawing Income from your Portfolio, Safe Withdrawal Rates and Market Downturns
In previous blog posts, I’ve commented on safe withdrawal rates.
Your withdrawal rate is calculated by taking the amount you are withdrawing from your retirement portfolio and dividing it by the value of your portfolio.
So, if you have a pension fund of £250,000, and you are withdrawing £7,500 per year, your withdrawal rate is 3%.
There has been plenty of research done about how high your withdrawal rate can be before you risk running out of money during your lifetime.
Your safe withdrawal rate depends on how old you are when you start drawing on your savings, whether you are single or part of a couple, your state of health, how much investment risk you can tolerate, and whether you will be spending the money from your portfolio on essential or discretionary items, amongst other things.
There are plenty of rules of thumb about safe withdrawal rates, with the most often quoted being the “4% rule”; this only applies if you live in the USA, and you don’t pay any charges for your investments, but it is often repeated and sometimes even applied in the UK.
The realistic UK equivalent of the US 4% rule is the 2.7% rule (this takes account of returns on UK investments, UK inflation and, importantly, typical charges for UK investment portfolios).
For most people, that is lower than expected, but there are plenty of ways of improving that figure (https://icfp.co.uk/how-to-increase-your-retirement-income/).
But what happens if the value of your retirement savings falls?
If you retired in December, your £1 million portfolio could have given you £30,000 per year if your safe withdrawal rate was 3%.
But if you waited until now, and that same portfolio had dropped to £850,000, should you reduce your starting withdrawal to £25,500?
There is some good news.
Safe withdrawal rates are based on the assumption that you retire at the worst possible time from an investment perspective (for most people, in the UK, that was June 1947, although if you have a particularly low tolerance of investment risk, it was May 1934).
As markets have fallen in value, it follows that you could start by taking out a higher percentage of your retirement savings now than you could have done at the start of the year.
For someone with a balanced portfolio, there have been times when the potential starting withdrawal rate has been extraordinarily high (12.5% in 1975, 10.5% in November 1920), and these high withdrawal rates have usually been the result of a decade of higher returns following retirement.
It’s not unusual for long periods of high returns to follow a market setback (the recovery from the Banking Crisis of 2007 is a good example).
As usual, US academics have looked into this, and they concluded that, when share prices appear to be low, you can adjust your withdrawal rate upwards. They used Shiller’s P/E 10 ratio if you’re interested!
They concluded that, when share prices are low, you should be able to increase your starting withdrawal rate by around 1%.
In practice, based on the example above, that means that the person who retires today with a portfolio of £850,000 should still be able to withdraw £30,000 per year, without running the risk of exhausting their retirement savings.
It’s essential to take personal financial advice before deciding how much to withdraw from your retirement portfolio, as your starting withdrawal rate depends on so many factors which are individual to you.
But in general terms, if you could afford to retire at the start of the year, you can probably still afford to retire today.