Win, lose or withdraw?

How fast can retirees sustainably draw down their retirement funds? That is a question which has caused much debate and anxiety in recent years, especially following the introduction of 'pension freedoms'.

We see three factors which affect the rate of drawdown as most worthy of consideration:

Asset drivers – The size of funds held and their risk and return characteristics

Spending drivers – Demands on your capital such as one-off lump sums e.g. once-in-a-lifetime cruises or financial support| for children or grandchildren trying to get on the housing ladder

Attitude to risk – How much risk we're prepared to take, both in terms of short-term volatility and the longer-term risk of the fund running dry

The degree of investment return uncertainty depends on the asset allocation strategy. Generally, strategies targeting higher returns will be more volatile; for example, investors allocating more to emerging market equities should typically expect a bumpier ride than those favouring government bonds.

Asset drivers

Size of retirement fund

A fund that's twice as big as another can support double the withdrawals (before tax) with all else being equal.

Expected return

Interest rates are a key driver of the expected return of any fund. In general, the higher interest rates are, the higher the level of income a given size of fund can support, rather like annuity rates being higher when interest rates are too.

The expected return from the chosen investment strategy over and above interest rates depends on both the asset allocation and views on those asset classes (there is no right answer). All else being equal, a higher expected rate of return affords a higher income.

Uncertain returns

However, we need to tread carefully, as higher returns generally come with higher risk. The degree of investment return uncertainty depends on the asset allocation strategy. Generally, strategies targeting higher returns will be more volatile; for example, investors allocating more to emerging market equities should typically expect a bumpier ride than those favouring government bonds. All else being equal, greater volatility leads to an increased risk of running out of money.

Spending drivers

Age

As retirees age, it becomes safer to withdraw a greater percentage of the remaining fund each year as the risk of outliving their retirement fund (longevity risk) decreases.

For pure income drawdown investors, the only way to protect against this longevity risk is to 'self-insure' by withdrawing income at a 'prudent' or 'sustainable' rate. However, the problem is that in old age the degree of prudence required can become crippling, pushing the sustainable rate below that available from an annuity. This may make annuitisation appear more attractive with age. Moreover, as we age, we may also favour a greater degree of simplicity.

Health

Being in poor health could be akin to retirees effectively being older (in terms of the mortality rates they are exposed to) than their years. Plainly the diverse range of retirees' health circumstances underlines how different pension investors can have widely-differing needs.

Spending patterns

These will vary hugely across individuals. However, most individuals are exposed to similar drivers. Some of these drivers act to increase spending over time, such as the need for inflation protection, and long-term care costs. In contrast, others tend to decrease spending. For example, pensioners tend to become less active over time. Some advisers like to think of a U-shaped spending pattern in retirement – outgoings decreasing at first (adjusted for inflation) but then tending to increase in advanced age. However, some researchers have expressed doubts over this pattern.

Inheritance matters

Inheritance goals are usually only a secondary objective, other than for those with the luxury of very substantial pension funds. However, our discussions with IFAs/wealth managers dealing with high net worth individuals suggest that inheritance objectives are becoming increasingly relevant to some investors.

Other sources of income

Many retirees will qualify for a state pension. In practice, access to such a backstop income influences other risk preferences – investors are often more willing to take greater risks with their pension funds if they have another source of regular income to fall back on, particularly if it is guaranteed (such as a defined benefit pension).

Attitude to risk

In the absence of annuitisation, investors bear both investment risk (given that, in general the return that will be earned on assets is not known in advance) and longevity risk (given that nobody knows their date of death in advance). This effectively rules out the 'perfect' scenario for many retirees, namely that they get to enjoy every last penny just before their time comes. Retirees need to adapt their investment strategy and their withdrawal rates over time to handle these risks. However, exactly how they adapt will depend on their attitude to risk. A retiree who's more willing to run the risk of exhausting their pension fund might be prepared to take money out more quickly. At the other extreme, those who want to play things ultra-safe would take the annuitisation route and accept the lower consequent income.

Important Notice:

This is not a consumer advertisement. It is intended for professional financial advisers and should not be relied upon by private investors or any other persons. The views expressed within this document are those of Legal & General Investment Management, who may or may not have acted upon them. Legal & General Investment Management is authorised and regulated by the Financial Conduct Authority and is the Investment Adviser to the UK Special Situations Trust, a UK authorised unit trust. Issued by Legal & General (Unit Trust Managers) Limited. This document should not be taken as an invitation to deal in Legal & General investments or any of the stated investments. Remember, the value of investments and any income may fall as well as rise and investors may get back less than they invest.

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