Wednesday, 2 July 2014

A Sobering Income Drawdown Demonstration One Year On

When we left our UK Invested Income Drawdown dependent Retiree’s a year ago there was trouble afoot.  Our 4% Withdrawal Rate Retiree, which remember is the Safe Withdrawal Rate (SWR) Rule of Thumb many talk about and even use, was particularly vulnerable having lost between 11% and 24% of wealth in only 6.5 years.  Since then a couple of notable things have occurred:

  • The 2014 budget saw the income drawdown rules again altered.  From the 27 March 2014 retiree’s are now able to withdraw from their pensions at the rate of 150% of the Government Actuary’s Department Tables (GAD Tables).  Additionally flexible drawdown, allowing unlimited withdrawals from your pension pot, is now available for anybody with a guaranteed income of £12,000.  Then from April 2015 these rules will change again and allow unlimited access to our pensions from age 55.
  • The second is that Professor Wade Pfau published research showing a UK retiree positioned with a 50% UK Equities/50% UK Bonds portfolio and drawing down using the 4% SWR rule of thumb would actually run out of wealth 23.8% of the time within a 30 year period.  Scary stuff given how loosely the 4% Rule is bandied around the personal finance blog world these days.  Professor Pfau then calculated that if history should repeat (and of course past performance is not necessarily indicative of future results) then to ensure you don’t run out of money over a 30 year period your withdrawal rate before investment expenses and taxes are deducted has to actually be less than 3.05%. 

Going forwards this is going to make life interesting.  For a retiree to draw down £24,856, the equivalent of current average UK earnings (Office for National Statistics KAB9 dataset), requires wealth (including Pensions, ISA’s and non-tax efficient investments) of £814,950 if we are to minimise depletion risk over 30 years according to Pfau’s research.  At the same time from next year we can grab whatever we like from a pension pot that on average only contains £36,800 at retirement according to the Association of British Insurers.  Of course many of us don’t just save in pensions (for example only 43% of my wealth is in a Pension of which only 14% is sitting with expensive inflexible insurance companies) and of course not all of us will withdraw crazy amounts to buy Lamborghinis (if the rules haven’t changed I’ll be withdrawing as much as possible to keep my total earnings just below the Higher Rate tax limit with the difference between spending and withdrawal being put into an ISA) but it’s probably uncontroversial to suggest it does have the potential to leave the uneducated very exposed.

With that in mind let’s look at how our UK Invested Income Drawdown dependent Retiree’s are doing one year on.  For consistency all assumptions are unchanged.  Re-emphasising some of these assumptions:

  • Our Retiree’s are drawing down at the stated withdrawal rate plus investment expenses.  This means any trading commissions, wrapper fees, buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% Initial Withdrawal Rate Retiree is actually drawings down at between 2.25% and 2.36% dependent on the asset allocation selected.   
  • All calculations are in real (inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
  • 6 Simple UK Equity / UK Bond Portfolio’s are simulated for our retiree.  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 and 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.
  • 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.

A 4% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 4% Withdrawal Rate, 31 December Value
Click to Enlarge

Our 4% Withdrawal Rate Retiree, meaning annual withdrawals of £4,000, is I would say now in some serious trouble.  Last year after 6.5 years of retirement between 11% and 24 % of portfolio value had already been lost.  Step forward a year and the situation has worsened again with between 14% and 25% of portfolio value now lost.  If this were me I’d now be starting to quickly reconsider either cutting back spend and/or looking for some supplemental income.

A 3% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 3% Withdrawal Rate, 31 December Value
Click to Enlarge

Dropping the initial withdrawal rate to 3%, or £3,000 withdrawn per annum, which including investment expenses is actually a withdrawal rate of between 3.25% and 3.36% and so very close to Pfau’s 3.05% SWR shows our Retiree pretty close to treading water at this stage.  Last year wealth depletion in real terms of between 3% and 17% had occurred.  Today the depletion is between 5% and 16%.

The 2% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 2% Withdrawal Rate, 31 December Value
Click to Enlarge

Even the situation of our lowly 2% withdrawal of starting portfolio value is still not looking great.  Remember, to achieve £24,856 per annum at this withdrawal rate requires wealth, that very few will ever attain, of £1,242,800.  A year ago even at this low withdrawal rate problems were still afoot with only one of the six portfolios above the initial £100,000 starting point.  Today we have seen a small improvement with two portfolios now above the magic £100,000 line.  The change in real wealth is between a positive 4% and depletion of 6%.  So after more than 5 years of this current equities bull market and we still have four of six portfolios under water.  Interestingly the two positive portfolios are both Index Linked Gilts based.

To Conclude

With us now more than 5 years into an equities bull market and 24 of the 26 portfolios examined above still under water it really does highlight the risks associated with living off capital and particularly blindly following a mechanical safe withdrawal method of any description.

This is all reinforcing some of my current thoughts which is to ensure you continually PDCA and to work towards withdrawing at a rate that is less than the interest and dividends received from your portfolio.

Are any readers out there currently in Income Drawdown?  How are you getting on?  I’d particularly like the musings of anyone who retired in 2007.

As always DYOR.


  1. "withdrawing at a rate that is less than the interest and dividends received from your portfolio."

    In 2007 the yield on a 75:25 FTSE tracker:UK gilts portfolio was probably around 3%, perhaps a shade more. The 2nd graph suggests that the notional 2007 retiree withdrawing an inflation adjusted 3% would today be down about 15%. Unless capital values increased, or a side income appeared, it looks like her capital may spiral downwards - scary.

    I am coming round to the idea of retiring on 100% equities with a small cash buffer corresponding to about 4% of the capital value. That buffer would equal one year of generous living expenses. Let's assume that on retirement day the portfolio yields 4%. Each quarter I would withdraw 1% of the portfolio's capital value from the cash reserve. If the market tanked i would have to cut my cloth and await a recovery. If the market rose (as it hopefully will over the long term) then my 1% of capital each quarter would leave some slack in the budget for rainy day fund/reinvestment.

    Sound sensible?


    1. Hi Brodes

      Thanks for your thoughts. My immediate reply would be what modelling or reading have you done to arrive at that strategy as it sounds very high risk to me?

      It was published in 2001 and has a US bias but if you have undertaken limited reading/research to date might I suggest a good start would be the Bernstein book The Intelligent Asset Allocator (more details by clicking on the RIT Recommends tab above). He shows with multiple back testing examples that holding more than one asset class may allow some free lunch. The free lunch being more return for less risk.

      Of course DYOR and all that.


    2. Brodes,

      Your plan illustrates the nonsense behind the whole 4% idea as a worthwhile rule-of-thumb. You imply you have room to cut back if things get tight. In that case your plan is the best. Go big (100% equities and cut back if you have to), if things go well step it up some too, why stop at 4%.

      The problem arises with those people whose pot is too small to cut back. In their case the 4% rule is probably dangerously generous.

      There is a huge difference between people with a more than adequate pot and those with a barely sufficient pot. 4% is not a one-size-fits all number and it never was.

      If you have a big pot you can afford to take risks. A small pot might give you financial independence but a big one gives a whole lot more!

      Paul S

  2. Thought you might like to have a read of this on defined contribution pensions.

    1. Hi HAM

      Thanks for this. A worthwhile read even if a bit US and age 65 retirement focused. Some initial thoughts...

      Part 1 supposedly challenges Modern Portfolio Theory (MPT). For this they model "the old investment advisor adage that stock weight should be about 110 minus a person’s age". This is exactly the starting point for my own portfolio. They then suggest 2 alterations:
      - Once you get to a certain age you stop switching from equities to bonds. This is certainly something I was intending to do - likely at the 60:40 point. My thought is does anyone actually continue switching forever? I'm not aware of it and so I don't think they've found anything new there.
      - Their other change looks to be simply to hold a "lot more" equities early and then switch at a faster rate before undershooting MPT for the first 5 years of retirement.

      Part 2 talks about Dynamic Allocation based on market valuations. This is exactly what I'm trying to achieve with the CAPE work that I post here regularly.


  3. I'd plumped for a 2% safe withdrawel rate after Monevator's post on the safe withdrawel rate and I feel vinidicated.

    However one question, is the £25k average earnings figure per household or per individual (I think from memory its the latter)?

    I wonder what will be the social consequences of this, are we going to end up working into our 70s stacking supermarket shelves like old people in South Korea and Singapore?

    1. Hi Anon

      It is my understanding that it is the average earnings for individuals in employment. So it's individual and you have to be in employment to be counted.

      "I wonder what will be the social consequences of this, are we going to end up working into our 70s stacking supermarket shelves like old people in South Korea and Singapore?" In the modern Defined Contribution low return world we live currently it seems clear to me that as a society we are saving nowhere near enough and so retirement ages are going to drift upwards. As people need to work longer because they haven't saved enough I have sympathy for 1 group of people and it's not the 70 year olds who can't afford to retire. I'm actually sympathetic to the new younger generation who are trying to get into the workforce but are being blocked by all the people who didn't prepare appropriately.


  4. You make a great point about people 'blindly following' the 4% SWR without doing their own research. What's scary is that 'experts' are predicting an end to the equities bull market so how will your graphs look when the bear markets take over? Of real interest is "the two positive portfolios are both Index Linked Gilts based", which I hadn't considered adding to my own portfolio previously.

    1. Hi weenie

      Exactly my thoughts when I stated "with us now more than 5 years into an equities bull market..."


  5. As ever, interesting post.

    I think the point has to be made that as we all know, we are all living longer and it could easily turn out that the average pensioner retiring at 65 will be drawing a pension for the next 30 yrs.

    The average return on equities far exceeds the return on bonds so I would question any sizeable allocation to gilts for a long term income drawdown plan.

    My own drawdown is just 2 yrs in and whilst I have PIBS (yielding 6%) I would not really consider gilts, particularly in the current climate. This together with a basket of income investment trusts will get the job done without too much concern over whether to aim for a target of 2.255% or 2.125% to ensure maximum chance of sustainable income - seems to be putting the cart before the horse.

    Enjoying the different points of view which can only be a good thing!

    1. Hi John

      As always really value your thoughts. Our strategies are quite different but at the same time a little similar:
      - We both have a "high" risk side. I go for direct shares for my HYP and you also buy direct shares. Additionally I buy OEIC's/ETF's where you prefer Trusts.
      - We both have a "low" risk side. I buy predominantly index linked gilts (plus have a bit of cash) where you prefer PIB's.

      Could it be worth comparing our returns over the long term? Not perfect of course as we'll have different weightings meaning our risks will be slightly different but possibly valid also as we're trying to achieve similar goals (retirement living) with the wealth accrued. Not sure how far back your records go but this has been my portfolio performance since I started counting:
      - 2008 -15.7%
      - 2009 26.0%
      - 2010 15.8%
      - 2011 2.7%
      - 2012 13.2%
      - 2013 5.6%
      - 2014 YTD 3.9% (estimated per our exchange yesterday)


    2. Thanks for the figures RIT - I think they stack up pretty well. My returns over the same period are:

      2008 -29%
      2009 35.7%
      2010 12.8%
      2011 - 3.1%
      2012 15.5%
      2013 13.3%
      2014 3.9% (YTD)

      For me however, investing for my pension income which I rely upon to pay the bills and put food on the table, the important consideration is not so much total return but maximum sustainable rising income.

      Whether capital returns are up or down in any particular year has very little impact. The use of gilts will obviously lower portfolio volatility but a high percentage allocation will depress yield.

      I believe I can cope with the volatility of equities and as they are most likely to provide the steadily rising income over the longer term - via higher yielding shares or income inv. trusts, this will be the better option for many in income drawdown imho.

      When the state pension kicks in (few years to go) I will review the % equities and may well increase this.

      Cheers, John

    3. Thanks John most interesting. Crunching the 2 sets of numbers shows that a punter investing £1 at the end of 2007 into the RIT portfolio would today have £1.57 and into the DIYI(UK) portfolio would today have £1.43. Shift it forward 1 year and the RIT portfolio has £1.86 and the DIY(UK) has £2.01. Would be interesting to watch this going forwards?

      Very good point on capital gains not being so important but rather sustainable rising income (at a rate equal to or greater than inflation). The whole point of the HYP portion of my portfolio.

  6. I retired in 2007. Good investments have included Cash ISAs at fixed rates above the RPI inflation rate, ns&i Index-Linked Savings Certificates, and a Physical Silver ETF. But best of all has been suspending ("deferring") State Retirement Pensions - 10.4% p.a. index-linked annuity-like returns. I didn't buy equities in 2007 because I thought the world was drunk on debt and would eventually have to pay up: hence the big punt on Silver. (There was a logical reason why I didn't choose gold, but I can't remember what it was.)

    As our ISAs mature we'll presumably start buying equities again, but just at the mo' we're filling loss-leader current accounts that pay interest rates above the RPI inflation rate in expectation that our ancient car will need replacing next year, and spending quite a bit on the house - for comfort, not as an investment.

    Come the autumn, nettles will have to be grasped. Norwegian or Swiss bonds? Japanese equities? EMs? TIPS? Tax avoidance stunts such as EISs? Our Gold ETFs, bought too late, have lost money but I'm hanging on to them.

    P.S. Pension deferral. Suppose your SRP is £6k p.a. and you defer for 5 years. You get roughly an extra £3k p.a. after restarting. That, as an index-linked annuity, would cost you in the neighbourhood of £100k. It actually cost you £30k (plus some interest forgone). And in our case we also had a tax saving, and due to some subtlety I don't fully understand, our Final Salary pensions were increased when we told them we'd suspended the SRPs. My oh my.

    1. Hi dearieme

      Great point on the pension deferral. All of my financial modelling assumes that the State Pension will not exist for me (either pushed out to a very high age or means tested). If I ever do become eligible at a point in time where I still have many years to live I'm thinking of deferring for many years as a portfolio depletion insurance. The deferral literature does not stipulate a maximum deferral period that I can find anywhere. If my wealth for any reason then depletes then I switch on the State Pension.


    2. The wonderful terms for deferral won't apply to you, mind; too expensive for us taxpayers to subsidise!

  7. Although I think the SWR analysis is good for getting a handle on the numbers, I'm not sure it describes what actually happens in practice. Needs vary over time and a fixed drawdown rate is not likely to be necessary or desirable.

    I took early retirement in 2011 on a FS pension, but not one that is large enough to cover all expenditure. My partner is still working, but I am also currently subsidising student offspring. Expenditure will go down in the medium term, but my partner will also retire, so dividends and interest will play an important part in managing that transition.

    Overall, my annual investment return is around 3%, excluding capital appreciation which, over the past 5 years, has been considerable. Effectively, I am drawing down about 0.5% currently, so, barring market falls, I am still in an accumulation phase.

    However, all this will change and change again as the family situation changes. I find the best way is to model capital and income flows year on year, based on known expenditure and likely income, using previous years to inform prediction.

    1. Great to hear from you SG. It's been a while... It really does sound like you are in a very sound place financially.

  8. RIT,
    What is your plan re housing? Rent is your largest living cost?

    Do you see a time when you might buy a house in the UK or do you still have plans to move abroad, if so, where?

    1. Hi LC

      When I started on this journey some 7 years ago I thought of the UK as home and buying a home for my family was a priority. As time has gone on I seem to drift further and further from that ideal.

      My aim is to live intentionally and simply with focus on family and good friends. Based on my learnings so far (including spending some time there) I'm leaning towards one of two European locations - Gozo or Puglia, Italy.

      Both regions have great unprocessed fresh food readily available, reasonable home prices (compared to the current UK nonsense, likely expensive also when compared to local salaries), great history, still value the family and beliefs I have a lot of time for. Additionally, Puglia particularly brings a lot of opportunity for going off grid to a reasonable level which will lower costs even further.


  9. RIT,


    I'd better go read up about Puglia now. Though being in Italy and them having such huge debt, first thought is that it might not be very tax efficient going forward. They will be determined to squeeze every penny out of people who own a few.

    1. Agree with that. They've already made a start with a new wealth tax on financial assets held abroad by Italian tax resident individuals (imposta
      sul valore delle attività finanziarie detenute all’estero or IVAFE) which took effect from 2012. The current tax rate is 0.15% from 2013 onwards. That of course is a bonus extra which comes on top of the tax on dividends/interest.

      If you want tax efficiency then as a non-Maltese domicile Malta/Gozo gives many more advantages IMHO.

    2. Just stumbled across this about Gibraltar going the opposite way. Highest ever surplus and GDP up 10% last year, debt to GDP only 25% - all that means they are slashing taxes.

  10. If you are thinking of deferring your state pension don't forget that, if you die before the age that you have chosen to defer until you personally will have lost all of the
    value of the pension that you could have drawn if you have not chosen to defer.

    Well - that much must be obvious to everyone .

    However - what may not be widely understood is that the deferred benefits that you have accrued prior to your death ( by not taking your State Pension ) are credited to
    your widow/widower.

    And then - of course - don't forget the tax that has to be paid on the pension.

    I really do wonder about some of the readers and contributors to this site.

    We may die later today / tomorrow/next week or next year. Some readers are going to
    leave behind them large IHT bills - which will definitely benefit any of those that do
    survive a bit longer. The future is always full of uncertainty - no matter how much you try to predict or prepare for it .

    1. Deferring your State Pension can be very efficient for IHT, because you are converting capital (the stuff you spent to compensate for the pension forgone) to income (the extra pension you eventually get).

  11. Is this whole post based on being 100% in UK stocks and bonds? This might seem an overly simplistic question, but who actually does that?

    Personally I'm internationally very diversified and I would imagine that most investors who care enough to have (or be aiming for) £1m in invested assets would be the same.

    So surely looking at pure UK stock market results is a bit irrelevant?

  12. Do you think you might be over analysing this problem? Revising your SWR down might be due to subconcious fear rather than objective analysis, especially as all this research will almost certainly bear no resemblance to how things actually play out for you.

    I would recommend focussing on a staggered withdrawl from the world of work to ease your transition and give you a lifeline in case anything goes wrong..

  13. Further to my previous comment - I did not make clear the point I was trying to make about deferred State Pension rights.

    Any increased amount of your pension that has been achieved by you deferring your
    pension is transferable to your surviving spouse on your death.

    So if you end up having increased your pension ( by deferral) by - say - £20 / week -
    then this £20 is added to your surviving spouse's State Pension until his/her death.