- aren't fortunate enough to have a defined benefit pension from your employer coming at some point;
- decide against buying an annuity;
- don’t have any non-investment income streams such as part time work;
then after allowing for whatever State Pension is due your way, you’ll be living off whatever wealth you have accrued during your working life (plus whatever return you can achieve on that wealth).
We've previously looked at how you might calculate how much wealth you need to build before retirement. Today I'm going to run a sobering simulation that demonstrates just how important it is firstly give yourself some contingency in those retirement calculations but then secondly monitor your progress once in retirement, adjusting where necessary (just as you did during the accrual stage), to prevent yourself from running out of investments.
Before we run the simulation let’s define the assumptions:
- Our retiree decides to pull the retirement trigger on the 31 December 2006. On that date the FTSE100 was 6,220, it peaked the following year and today it sits at 6,308. That’s a nominal rise of only 1.4% in around six and half years. You've probably guessed our retiree retired just before the Global Financial Crisis (GFC) took hold.
- Our retiree removes his income for the following year on the 31 December of each previous year. That income is placed in a safe place where a derisory amount of interest is earned.
- All calculations are conducted in real (inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today. The inflation measure used to correct for sterling devaluation is the Retail Prices Index (RPI).
- 6 Simple UK Equity / UK Bond Portfolio’s are simulated for our retiree. The mix includes our retiree being conservative (25% UK Equities : 75% UK Bonds), standard (50% UK Equities : 50% UK Bonds) and aggressive (75% UK Equities : 25% UK Bonds) when it comes to portfolio risk. Two different bond types will also be used in the simulation.
- The UK Equities portion is always the FTSE 100 where the iShares FTSE 100 ETF (ISF) is used as the proxy.
- For the bonds portion a simulation is run against UK Gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy. We also run a simulation with the bond type I prefer in my own portfolio, UK Index Linked Gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
- Our retiree rebalances to the target asset allocation on the 31 December of each year to manage risk.
- Only fund expenses are included. Trading commissions, wrapper fees, buy/sell spreads or taxes are not.
- The wealth accrued at retirement (the 31 December 2006) is £100,000. To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree to have £600,000 just multiply all the subsequent pound values by 6.
Let’s look at some differing initial withdrawal rates.
A 4% Initial Withdrawal RateThis initial withdrawal rate is the one typical used as a rule of thumb for Safe Withdrawal calculations. It says that if in the first year of retirement you withdraw 4% of your portfolio, then yearly up rate your withdrawals by inflation, the end result will be that you won’t exhaust your portfolio in your lifetime.
In our case because we are already allowing for inflation correction in the wealth value we don’t correct the withdrawals. A 4% withdrawal rate means £4,000 being taken from the portfolio every year for the rest of our retiree’s life.
The performance of our retiree’s portfolio is shown in the chart below. Unfortunately it’s not good news. In the best case, the 25% FTSE 100 : 75% UK Index Linked Gilts portfolio, 11% of portfolio value has already been lost. In the worst case, the 75% FTSE 100 : 25% UK Gilts portfolio, 24% of wealth has been lost. All of that has occurred in only 6.5 years.
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Will the portfolio ever recover from here if our retiree was to continue withdrawing a real £4,000 per annum? Of course only time will tell but if it was me I’d be slowing down spend drastically and looking for some other income streams.
A 3% Initial Withdrawal RateEven if we drop the initial withdrawal rate to 3%, or £3,000 withdrawn per annum, our retiree is still in some trouble. Our retiree has lost between 3% and 17% of wealth in real terms. I’d still be taking action.
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A 2% Initial Withdrawal RateDrop our withdrawal rate to a lowly 2% of starting portfolio value and problems are still afoot. To put 2% into perspective our retiree would need wealth of £1 million for an annual income of £20,000. In this case only one of the 6 portfolios is above the initial £100,000 starting point with two very close to holding station.
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To ConcludeWhen I ran these numbers it hit me really hard how serious this retirement planning business really is. It is not a game to be played lightly. Get it wrong or just choose the wrong retirement day and it could mean a retirement that is not what was envisaged. It’s certainly encouraged me to keep reading and to take nothing for granted.
As always DYOR.
Last edited: 17 June 2013 at 20:20