How to make your pension last: an age-old conundrum
This article I wrote appeared as the cover story for the FT Money supplement to the (UK) Financial Times Weekend newspaper on April 10. I include a note about their readers’ reactions at the end of this blog post.
Bill Sharpe, the US economist and Nobel Prize winner, called it “the hardest, nastiest problem in finance”. How much can you sustainably withdraw from your pension pot? And what’s a sensible way to allocate assets in it?
The problem of how to draw down money from your retirement fund – “decumulation” in the industry jargon – is simple to state but not easy to tackle. Let’s say there’s £100,000 in your pot. How long will you live? You don’t know. What return will you earn on the money? You don’t know that either.
Baby Boomers, those born from the end of the second world war to the mid-1960s, are retiring in their millions these days, with no perfect answers to these questions. I’m even older than them, being a second world war baby. So, in the absence of an optimal solution, how do you find one that works for you, based on well-founded principles?
BREAK DOWN THE PROBLEM
My wife and I had pension savings and other assets but were not members of defined benefit pension schemes. In my career as an actuary and pension fund consultant, all I knew about were the principles underlying these schemes. So to bring that experience to bear, I decided to conduct a thought experiment: I would project a defined benefit scheme forward some decades, and imagine that the two of us are the last surviving members.
The principles are straightforward. Make a reasonable assumption about the average future lifespan of the members. That, along with the benefit formula, leads to an estimate of the annual cash flow promised to the members. You know the assets in the fund. Make some reasonable assumptions about the investment return the fund will earn. That tells you whether the amount in the fund, plus the future returns, will be sufficient. If it’s insufficient, you need to add more money.
When there are only two of us left, and the withdrawals we’d like are too large to be supported by our pension pot, nobody is going to contribute more money for us; instead, we need to reduce our withdrawals.
There were three steps involved. First, we assessed our combined longevity and its uncertainty. Second, we needed to balance cash flow safety and investment growth; in other words, decide on our tolerance for taking investment risk. Finally, we needed to estimate the pace at which we can sustainably withdraw money to spend.
It’s like driving on a long journey. We know where we are on the map, and we’ve made our own decisions on direction and speed. There’ll be corrections as the map unfolds, but we feel we’re in the driver’s seat, and that’s as much control as anyone can have.
HOW LONG HAVE YOU GOT?
The first question is how long would we live. For a large scheme with many members, average life expectancy works fine as an estimate. For us, outliving the average was a big financial risk, with a 50/50 chance of this happening by definition. I thought we should reduce the risk and see what the numbers looked like when we used a longer time horizon, one that, not 50 per cent, but only 25 per cent of couples like us would outlive. I used http://www.longevityillustrator.org/ a longevity table by the American Academy of Actuaries and Society of Actuaries.
What did that mean for us? When I reassessed our position after I turned 70, our “joint and last survivor” life expectancy (the likely period until the second death) was 26 years, meaning that 50 per cent of couples of our ages would live longer. The period that only 25 per cent would outlive was 31 years, so that became our initial planning horizon.
We could have been even more cautious and chosen the horizon that only 10 per cent of couples of our ages are likely to outlive. That would have been 36 years.
The second step involved balancing cash-flow safety and investment growth.
Take it as a given that we wanted growth. So: invest our pot in a global equity index fund. Yes, there are alternatives, but this was simple, inexpensive and didn’t require expertise. But wait. Putting 100 per cent in growth assets from which we need to make periodic withdrawals exposes us to something called “sequence of returns risk”.
Because we’re always withdrawing money, our assets decline over time. So if we have poor returns early, there won’t be enough of a base to make up the losses even if the later returns become above average. So we need to be able to make withdrawals without affecting the shortfall too much.
What do pension funds do when faced with this problem? They don’t invest 100 per cent of their assets to seek growth. They invest some assets in ways that automatically match a few years of cash flow, so they get that early cash flow without touching the growth assets.
How much is a matter of risk tolerance. For me, I’ll feel OK withdrawing cash flow from the growth assets as long as they haven’t lost purchasing power. In other words, I want a return of at least 0 per cent after allowing for inflation.
That left me with a specific question to investigate. Over the past 50 years, what period of consecutive years was necessary after a decline until the market recovered, 75 per cent of the time? (I chose 75 per cent, because that would give us the same chance of investment success as we sought with our longevity risk.)
The answer varies by country. In the US, it’s 5 years; in the UK, 6. Suppose you place six years of withdrawals in safe instruments and the rest in growth assets. If the market falls and you use your safe instruments for cash flow, historically 75 per cent of the time your growth assets will have recovered before you need to make a withdrawal from them. (By the way, the average “real” annual sterling return on the global portfolio was 5 per cent.)
What if we wanted a 90 per cent chance of growth assets recovering after a fall? In the US, we’d need 11 years of withdrawals in cash-like assets. Historically, this wasn’t feasible in the UK: the returns were too volatile.
So let’s explore one other well-tested pension fund strategy: replace a part of the equity exposure with fixed income assets, like UK government mid-term bonds (“gilts”), accepting a reduced long-term return in order to limit short-term volatility.
Historically, a portfolio with 90 per cent growth assets and 10 per cent gilts needed 5-year holding periods for a positive real return 75 per cent of the time, and only 6 years for a positive real return 90 per cent of the time. Raise the level of gilts to 20 per cent, and the portfolio needed the same 6 years for 90 per cent positive real returns, but only 3 year holding periods for positive returns 75 per cent of the time. We used 5 years.
This is encouraging. But bear two things in mind. First, by introducing mid-term gilts you’re giving up either 10 per cent or 20 per cent of the so-called “equity risk premium”, the excess return provided by the stock market over a risk-free asset. And the last three decades have been an exceptionally favourable period for gilts, as interest rates fell and enhanced the value of existing gilts.
Second, all my analysis is just history. I’m not expecting it to repeat itself. If it repeats itself in broad terms, well and good. If it doesn’t – well, I don’t expect it to, and I’ll adjust.
HOW MUCH TO TAKE
So to the third and final step. With our 25 per cent risk exposure level, how much can we actually withdraw? And what if our risk tolerance is not 25 but 10 per cent? Without these numbers, we don’t know how much future spending is sustainable, and how we’ll feel about it.
I designed a spreadsheet to answer these questions, and a technically proficient friend built it for me.
Remember that in the 25 per cent risk situation, my wife and I would need to hold 5 years of cash flow in safe assets and the rest in growth. I used 0 per cent as the future annual real return for these assets and 4 per cent for the growth assets. (That’s lower than history suggested, but I wanted a further margin of caution. Also, in these days of low interest rates, that hoped-for 0 per cent annual real return on the safe assets isn’t coming through.)
Every year we take a year’s indicated withdrawal from the safe assets, and replenish them by cashing in from the growth assets. The withdrawal (to be increased by inflation each year) must be calculated so as to last 31 years.
Answer: for each £100,000 of our pension pot, the indicated annual sustainable withdrawal was £5,080.
So the safety amount is 5 years of that, or £25,000 in round numbers. To my mind, this isn’t an investment; it’s our personal self-insurance bucket against a market decline. The remaining £75,000 goes into growth assets (perhaps diluted to 90/10 by gilts). By traditional measures that’s an astonishingly high percentage. But it’s based on long-standing pension principles.
Traditionally, one’s percentage exposure to growth assets in decumulation is suggested to be 100 minus your age. For a 70-year-old, this means 30 per cent in growth. But that’s a rule of thumb, and I’m defining caution much more clearly: not an arbitrary reduction in volatility, but avoiding sequence-of-returns risk with a (historical) 75 per cent chance of success.
What would the result be with the 10 per cent risk posture, involving a 36-year horizon and 11 years of anticipated withdrawals in the self-insurance bucket? Answer: for each £100,000 of our pension pot, the annual sustainable withdrawal would be £3,930, so the self-insurance bucket holds 11 times this amount (£43,230) and the remaining roughly 57 per cent goes into growth assets. That 57 per cent is also dramatically higher than traditional practice suggests.
Now, with these numbers available, we could make our decision. We scaled the annual withdrawal numbers to reflect our total pension pot (which includes all our financial assets, not just our tax-deferred assets) and added in our Pillar 1 pensions (in the UK, the state pension). We went for the higher withdrawal level at a risk tolerance of 25 per cent. We didn’t consider anything in between 25 per cent and 10 per cent.
Here’s a table showing how the indicated withdrawal per £100,000 pension pot changes with the length of the planning horizon and the number of years in your self-insurance bucket. Multiplying by your own pot and adding your other sources of income, you can see what’s indicated for you.
(Based on annual real returns of 0 per cent in the safety bucket and 4 per cent in the growth portfolio)
THEORY AND PRACTICE
What happened when we put all this to work? The global stock market index dropped about 8 per cent in December 2018. We took no action and decided to see where we were in five years. When the global index fell 8 per cent in February 2020 and a further 13 per cent in March, our attitude was the same.
Of course, we were lucky that the market recovered quickly. It was much worse from September 2008 to February 2009, when the cumulative fall was 40 per cent. But again we were lucky, because before the end of 2009 the markets had recovered that loss.
What if we’re not lucky in the future? Then after five years the market won’t have recovered, and we’ll have exhausted our self-insurance bucket, and we’ll be forced to cash out from the growth assets at some low level, with no further protection from market volatility.
If this happens, we could at least avoid a massive cut to our withdrawal amount by spreading that reduction over the remaining period to the end of the planning horizon. A really bad outcome means five successive years of gradual reductions, followed by complete exposure to market volatility.
There’s another safety factor here. When one of us passes away, the 25 per cent longevity estimate for the survivor will fall and the required spending to retain the lifestyle will also fall, since it only has to support one person. Our assessment doesn’t take either adjustment into account in advance, so we have two further margins of safety.
Of course, there are risks. Market declines might be steeper and longer than history suggests. If that happens, the gradual declines in our withdrawals following a negative return won’t be enough. We’re conscious of that.
One takeaway from this exercise is that you can afford to take much more investment risk with your portfolio than conventional thinking suggests. But it has required discipline; indeed, many disciplines. And perhaps the hardest is the ongoing discipline.
You need to gather the relevant information about your pension pot; have an idea of a desirable budget; use longevity tables; have access to something like the spreadsheet I mentioned; and make sensible assumptions about future investment returns.
Those are the set-up tasks; the ongoing disciplines are creating the self-insurance and growth portfolios, making the withdrawals and rebalancing periodically (which is much more tedious than making the withdrawals).
You may be wondering whether you want to sign up to this or will be able to maintain it throughout your retirement. Of course, if you want to proceed but lack confidence, you can ask a pensions adviser or financial planner for advice.
But if you’ve done all the start-up work, pat yourself on the back. And if you’re systematically making the withdrawals and rebalancing, you’re a true champion.
Don Ezra, now happily retired, is the former co-chairman of global consulting for Russell Investments worldwide, and the author of “Life Two: how to get to and enjoy what used to be called retirement”
I’m delighted that the piece seems to have been well received. A friend emailed me, showing me a reader’s comment that he said wasn’t exceptional:
“This is a brilliant, lucid piece of analysis In fact, despite years of looking for this information, this is the only good piece of analysis I have ever seen on this subject. Congratulations Don Ezra. This article alone has made my FT subscription worthwhile.”
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.