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Written by: Ankul Daga
03/06/2021
One of the most difficult questions you face if you’ve just retired is: will your pension last for as long as you are likely to need it?

It’s all the more demanding if your assets are invested in the stock market and you’ve been through a dip such as we saw in early 2020, when a mixed portfolio of bonds and shares could have lost a fifth or more of its value in just over a month.

Against such an unnerving background, anyone relying on their portfolio to live on will have wondered how they could prevent their money running out prematurely.

One common strategy used is to set an annual level of income from the portfolio, and then increase it annually in line with inflation. This provides a high level of certainty about what income is likely to be from year-to-year, at least in the short term.

Withdrawal methods

You might set an initial withdrawal of, £40,000 in the first year and then raise it each year by the inflation rate, say 2%, to give £40,800 in the second year, and just over £41,600 in the third year.

This makes budgeting easy, although by delineating portfolio balance from the spending decision there is a substantial risk that you could run out of money quickly. If you suffer a run of bad markets and your portfolio loses value, you would be withdrawing a bigger chunk /proportion of the pie.

An alternative would be to only spend a set percentage of the portfolio every year. A typical rule of thumb is that around 4% or 5% of a portfolio is a sustainable annual amount to withdraw. Adopting this approach, means you would never run your pot down to nil, but you would have much less certainty about your income. Your income would fluctuate from year-to-year along with the gyrations on markets.

A more flexible approach

We would suggest a third approach that treads a pragmatic path between these two extremes and captures some of the benefits of both. We call it ‘dynamic spending’ (1).

In doing so, you set your annual income as a cash sum, say £40,000, but then adjust it year by year depending on inflation and how well your portfolio performs, subject to a floor or ceiling.

Say you set a ceiling of +5% and a floor of -2.5%. If in the first year the value of your portfolio rises by 20%, the ceiling would mean that your income would rise by only 5% in real (inflation adjusted) terms to £42,800.

If, however, the value of your portfolio fell by 20%, the floor would mean that your income would drop by only 2.5% in real terms to £39,800. In this way, the ceiling helps to build a buffer in rising markets, while the floor helps to maintain a reasonable level of spending after a sharp decline in the portfolio.

Benefits of dynamic spending

The benefits of this flexible approach to income is that it builds up over time. To give you an idea, we compared both these methods against various benchmarks of success, such as the chance of running out of money and how much you can sustainably spend. In all cases, the dynamic spending approach scored more highly.

For example, we looked at how much you should be able to draw down from an £800,000 portfolio over 30 years with an 85% chance of not running out of money by the end of the period (2). We found that dynamic spending would allow an average income of £46,400 – substantially more than the £37,600 allowed by the inflation-plus strategy.

With a more lavish starting income of £50,000, the success rate fell markedly with the first approach. But it was still much better than 50:50 at 73%, whereas it slumped to less than one in three for the second approach (29%).

There was good news for the next generation too. We found that the beneficiaries of our £40,000 initial spender could reasonably expect to be left more than £550,000 with dynamic spending, even if they died after 30 years of retirement. By contrast, the inflation-plus retiree’s bequest would be less than £350,000 (3).

Nobody can predict the future but, we think it shows that there is a sensible path that prudent retirees can follow to reduce the chances that they will outlive their savings.

Staying flexible about how you manage your spending should give you much needed peace of mind as you face uncertain and sometimes volatile markets.

  1. Sustainable spending rates in turbulent markets, Ankul Daga, CFA, David Pakula, CFA and Jacob Bupp, Vanguard Research Note, January 2021.
  2. To model the performance of the portfolio over 30 years, we used the Vanguard Capital Markets Model, a proprietary forecasting tool that provides investors with a range of possible future expected returns for a wide range of asset classes. We assumed a diversified portfolio consisting of a 60%/40% equity/bond mix allocated between domestic and international investments. For more details about the assumptions used in our modelling, see Sustainable spending rates in turbulent markets.
  3. These tests were run on the same basis as our earlier examples, i.e. an £800,000 starting portfolio over 30 years.

Ankul Daga is an investment strategist at Vanguard UK

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