Savers are “running the risk of retirement ruin” by overestimating how much income they will be able to take from their pension pots, new research suggests.
Those attempting to manage their own retirement investments are particularly vulnerable to running out of money too soon, according to the latest report to highlight the dangers lurking in the so-called pension “freedoms”.
The received wisdom is that 4 per cent a year is a safe level of income to take from your pension to prevent it being emptied prematurely. Not only is that rule of thumb inaccurate, but it’s increasingly seen as overoptimistic, with 2.5 per cent now considered a more sustainable rate.
Yet research by Retirement Advantage found that savers approaching retirement typically believe they will be able to take income of 7 per cent or more each year from their pension pot.
It asked over 50s what rate of income they could expect to take each year from a £100,000 pension pot without running out of money. The consensus was that 7 per cent would be safe, while one in four thought they would be able to take 8 per cent or more.
“Our research shows people are well wide of the mark when thinking about rates of withdrawal, and unless they receive financial advice, are running the risk of retirement ruin,” warned Andrew Tully, pensions technical director at Retirement Advantage.
“With such a wide range of views on what people consider a safe rate of withdrawal, the best option is to review your income needs and the sustainability of taking that level of income every year.”
Working out a sustainable rate of income withdrawal can be a complex undertaking, underlining the importance of taking professional advice. In reality, however, large numbers of people are navigating the newly flexible pensions environment on their own.
The vast majority of savers previously used their pension savings to buy an annuity that would provide them with a guaranteed income throughout retirement. That was until the so-called pension “freedoms” took effect in April 2015. Now drawdown is becoming the mainstream retirement option, allowing savers to keep their pension invested while taking income from it.
“As more people now choose drawdown over an annuity, we’ve seen the shift of responsibility move to the individual to ensure they manage their retirement fund effectively,” Tully noted.
One of the biggest threats to pension pots in drawdown arrangements is a phenomenon known as pound-cost ravaging. This refers to the impact on a fund when income continues to be taken from it even as it loses value to market volatility. Not only does it accelerate the erosion of the pot, but the nature of investing in retirement makes it difficult to recover any losses incurred.
So how much income should, in theory, be safe? The 4 per cent rule of thumb came from US financial adviser William Bengen, who in 1994 arrived at that figure as the initial “safe withdrawal rate”. It’s frequently misunderstood, however. For instance, the 4 per cent rate only applies to the first year of retirement, after which the amount is adjusted for inflation.
But for UK investors the safe withdrawal rate should be lower, according to analysis by Morningstar, due to factors including fees and future UK investment returns that are expected to be lower than global averages. It believes retirees in the UK should use an initial safe withdrawal rate of around 2.5 to 3 per cent.
“Setting the right income withdrawal level for drawdown plans is one of the trickiest decisions people have to make,” said Rachel Vahey, product technical manager at Nucleus Financial in Edinburgh.
“They have to walk a fine line between withdrawing too much and running out of money early, and not withdrawing enough and suffering financially in their retirement with too much money left over.”
It’s made even harder by not knowing how long you’ll need the money for (although the Office for National Statistics website has a life expectancy calculator tactfully inviting you to find out how long your pension will need to last).
That’s one reason why there’s no one-size-fits-all approach to taking income, said Vahey.
“Instead, people have to keep an eye on their retirement plans and regularly look at external factors such as investment returns, market conditions, inflation, and personal factors such as circumstances and income needs.”
Investors should take a flexible approach and bear in mind that income levels can be changed each year to reflect individual circumstances, Vahey added.
“The secret is to adopt the mantra review, review, review – and look at your retirement plans regularly,” she said. “And getting a regulated financial adviser is the best way to assess your plans and make the right income decisions for your future.”