The Retirement Rule of Thumb and What’s Wrong With It
We all know the formula E=MC2, but few of us can explain Einstein’s General Theory of Relativity.
You’ll be pleased to know that you don’t need to be Einstein to work out how much you can take out of your retirement savings.
However, if you use the headline rule of thumb to determine how much income you should withdraw from your savings or pensions, the consequences could be very damaging.
The 4% Rule
30 years of research into retirement funding has somehow been condensed into the “4% Rule”.
According to this ‘rule’, you take your pension fund, and multiply it by 4%, to work out how much you can withdraw from your savings in year one.
Then you increase that figure every year by inflation.
And, according to the rule, there’s no chance that you will run out of money during your retirement.
So, if you have a pension fund of £500,000, you can withdraw £20,000 in year one, and increase that amount by inflation every year, and you’ll never run out of money.
This sounds straightforward, and could be applied to all sorts of retirement savings, making it easy for people to work out how much income they can enjoy, and whether alternatives, like annuities are attractive.
You can even quote the name of the author of the research (Bill Bengen), if you want to make it sound like you really know what you are talking about!
Sadly, the 4% rule is misleading, dangerous and, I’m sorry to say, just plain wrong!
What’s Wrong with It?
Firstly, let me say that Bill Bengen has contributed hugely to the academic research into retirement withdrawals, and we wouldn’t know what we know now without him. It’s unfortunate that his name has been attached to something he didn’t intend to be used around the world.
The 4% rule only applies if you live in the USA, invest in a portfolio made up of US shares and Treasury stock only, don’t pay any charges, don’t pay tax and aren’t in a position to vary the amount you withdraw from year to year (i.e. you are using the withdrawals to cover essential expenditure only).
And it only applies if share prices are high.
If you do use the 4% rule, you do need to make sure you die thirty years after you started taking money out of your savings too.
So, if that’s you, go ahead and use the 4% rule!
Bill Bengen’s theoretical framework was a starting point for retirement withdrawals, so it is helpful, but adopting it to manage your own retirement savings isn’t a good idea.
You will probably be taking too much money out of your savings, and the is a good chance you will run out of money.
Things That Can Help
• The 3.7% Rule.
Bengen’s work was extended to other countries, to identify whether Americans had experienced better returns and better withdrawal rates than other countries. The research identified that the USA has experienced, pretty much, the best investment conditions of all of the developed nations over the last 120 years, so the US withdrawal rate of 4% is amongst the highest around the world.
As an aside, it identified that the UK equivalent of the 4% rule is the 3.7% rule. That is helpful, but remember that the other conditions of the 4% rule still apply, so the 3.7% rule is still not much use!
• Deduct 50% of the annual charges from your withdrawal rate.
Further research showed that it is sensible to deduct half of the annual charges from your withdrawal rate.
In the UK, charges on retirement savings are typically around 2% per year of the value of your fund (our charges here at Informed Choice are lower than this!), so you would deduct 1% from the gross withdrawal rate to arrive at the net figure. So, maybe, in the UK, we could start with a 2.7% rule.
• Know your life expectancy.
Bengen’s rule was based on a 30 year retirement; at age 65, life expectancy for a man is 22 years, and for a woman, 25 years (life expectancy for couples is different – see last week’s post).
The good news is that, if you retire at 65, you may be able to start by withdrawing more than the usual 2.7%.
But if you expect to live 40 years, you might need to reduce the starting amount.
• Take good tax advice.
Bengen’s rule assumes you pay no tax on your withdrawals.
The amount of tax you pay on withdrawals could be nothing (e.g. if you are drawing from an ISA fund). But for taxable investments and pensions, the rules are complicated, and many people are able to reduce the amount they pay in tax (and the amount they can spend) by taking good advice.
However, if you don’t know how much tax you will pay on your withdrawals, you won’t know how much you can spend!
Simply knowing how much tax you pay is an essential part of your planning.
That doesn’t sound like much!
That’s a reasonable conclusion to reach! I would be disappointed to find out that, if you have built up £1million in retirement savings and you decide to use a sensible rule of thumb, you should start by withdrawing £27,000 per year (before tax).
The good news is that there are plenty of ways to increase this amount.
Having a bespoke retirement income plan prepared for you is the best way to increase the amount you can spend. I’ll tell you more about that next week!