Withdrawal strategies in retirement

Recent reforms to the pensions market in the UK have expanded the choice available for accessing pension savings.  However, with greater choice comes greater complexity. If retirees do opt to draw down their pension, they must decide how the remaining money is invested, and also, how they will set their withdrawals to sustain their desired lifestyle in retirement. Those that don’t get this right  risk running out of money too soon.

Whether they are aware or not, employers play a very important role in educating their staff about the options available to them.  Facilitating a drawdown option, but providing no decision making support around the process could lead to complaints from members who have made ill-informed decisions.

In this blog we take a brief look at the ‘annuity puzzle’; and assess some popularised strategies employed to manage drawdown strategies, how they work, and consider their pros and cons.  We wrap up with what we think individuals want from their drawdown arrangement to manage their retirement income.

The annuity puzzle

When asked, a majority of individuals near or at retirement age say they want a guaranteed income payable for life with no investment risk to manage. They also say that they don’t want to buy an annuity because they don’t want to make irrevocable decisions and they want to have access to their money as well as wanting it available to their heirs when they die. So, what members want has all the features of an annuity, however, that’s one financial product they know they don’t want to buy. This removes the risk of outliving the fund and the need to manage ongoing investment decisions.

This is known as the annuity puzzle.  

The 4% rule of thumb

This rule of thumb is that as long as a retiree withdraws no more than 4% of their initial portfolio on an annual basis during their retirement years, they should not run out of money. With the new pension freedoms, this rule has gained increasing prominence, but individuals should be wary of rushing into this strategy.  It is worth nothing that this originated in the US over 20 years ago. Critics are arguing that this rule is outdated and call for an even lower safe withdrawal rate. So, is it just the case that the 4% needs to be adjusted downwards to make the rule work better? If only it were that easy. The rule of thumb basis ignores a vital risk that individuals in drawdown need to be aware of, that is of generating positive returns whilst avoiding the impact of a drop in market values. When in drawdown falls in market value of a portfolio can only be repaired by reducing the income that is taken leading to a desire for low volatility funds, which leads to lower potential returns.

If the individual has other resources available, such as the state pension and/or a defined benefit position, they are more likely to be able to be a position to take on the risks associated with a simple rule of thumb approach.

Allocated investment strategies (jam jar approach)

An alternative approach to drawdown planning is to divide retirement funds into sub-accounts (or jam jars if you will), devoted to specific objectives or time horizons. For example, splitting the pot across annuities, fixed income investments, bonds and stocks allocated to different purposes e.g. mending the roof next year, inheritance, regular income needs. The main advantage of this approach is that it can help retirees to rest assured during periods of market downturn, with the knowledge that they have secure assets in place to meet their different needs.

This strategy does have its downfalls and although it is intuitively appealing, allocating different funds for different purposes may actually lead to lower returns and higher failure rates. The approach does not consider portfolio in a wide enough context and may well lead to counterintuitive decision making – taking more risk in one jam jar and less in another at the same time.

What do people need to know to help them through drawdown?

With the increased freedom to withdraw pension savings, retirees now have a much greater individual responsibility and they are looking to their employers to help them with their decisions.  Below we have detailed some of the key areas that we think an individual embarking on drawdown would have on their ‘wish list’ to enable them to have confidence in the offering and their decision.

• Help to determine how long their money will last under their planned strategy
• A warning trigger in place when their money is running low/falls significantly behind the strategy
• Easy to choose investment options
• Low volatility investment options with exposure to a range of assets
• Easy access to their money
• No irrevocable decisions

With so many options available in the market today, communication and clarity around drawdown strategies is essential for helping employees to make informed decisions around their retirement.

For more information, read our latest whitepaper: ‘How to spend it? Withdrawal strategies in retirement’ here.