19th August 2019
Welcome to Ireland’s #1 Personal Finance Blog and Podcast, with me Paddy Delaney! This week we explore an important topic for many, and that is managing our income when we leave full-time employment. When we enter ‘Life 2’ we are switching from accumulation to spending, which is a big shift for many people to take. I hope this piece offers some insights that will help you.
In this article I aim to answer the following questions that I frequently hear in working with clients who are in this stage, and for many are a cause of concern, until answered:
A Word About Annuities:
The majority of what we are analysing here now is focused on drawing one’s income from an Approved Retirement Fund. As we all know an ARF is not the only option, annuities can offer a potential solution for many. If you were satisfied to accept 3% per year from your pension pot, and have it guaranteed for life then an annuity might be the one for you. However, the majority of individuals will continue to refuse an annuity on the basis that historically at least an ARF offers a higher level of income, albeit with a level of danger that their fund will expire before they do.
A possible strategy that we have mentioned before is utilising both an annuity and an ARF to manage one’s income in retirement. The intent here being to use a portion of your pension pot to buy an annuity, generating income needed each month to cover your must-pays (Utilities, food, medical etc). The remainder of the pot would be invested in an ARF, and drawing the income for spending on discretionary items such as holidays, eating out etc. We will explore this in detail as a specific strategy in the coming weeks.
How much can I take from my ARF in retirement?
Over recent weeks we have delved into sustainable withdrawal rates, spoken to one of the leading technical experts on the subject, and explored various strategies of income draw-down. What we have yet to explore is the rate of spending we pursue, and the impact that can and does have on our life-time income total. We’ve explored various situations, and several different portfolios. We have analysed this from every different angle conceivable. The 4% rule holds up in the vast majority of scenarios. Even when the 4% rule is stressed given the revenue rule of taking 5% from age 71 on-wards, if structured in the optimum way it has a favourable probability of success. Unlike Bengen’s original research this does include the considerable aspect of annual fees and charges on retirement plans. Even allowing for these the 4% rule, indeed a stretch to 4.5% has been a favourable and most importantly a prudent withdrawal rate to strive for.
Will that continue to be the case in future years, nobody knows. If you believe in the constant upward curve of equities, and despite the constant volatility, indeed because of it, that over a multi-decade retirement these equities will continue to generate sustainable incomes of at least these rates.
Spending Strategies In Retirement:
We have had many conversations about the erosive power of inflation on an income over a multi-decade period. Most of us appreciate that fact, and that we want our income to increase in line with inflation each year. That is fine however it does put additional strain on the pot from which you are drawing that income. In an effort to both achieve the desired income and to maximise the probability of your pot outliving you we can be flexible in our spending.
One such strategy of delivering sustainable income and reduced anxiety is what is known as the Guardrail strategy. Jonathan Guyton from the US, a practicing CFP in Financial Planning developed this strategy a number of years ago, and it has held up well, at least based on my own research….
Is It Effective?
So first things first, this is what we really want to know of course! In our (now well-worn) scenario we have a pension pot of €1m, we are drawing 4.5% from age 65 to 70, 5.5% from 71 on-wards.
To be clear, that is not 4.5%/5.5% of the pot value in each year, it is 4.5%/5.5% of the initial pot value, so €45,000 and then rising to €55,000 each year, while also taking increases each year for inflation. In this particular scenario we are paying 1.2% total fees on the pot value each year, and our portfolio is a very conservative one with 60% blended Equity and a whopping 40% in Bonds (might not be what we advocate here but bear with me!). We are aiming to draw this income for 30 years, to 95.
When we analysed the prudence of this approach, given the above metrics, we can see that this strategy only succeeded in 40% of scenarios. However, without increasing the equity holding we were able to increase the probability of success to 72%. This is really significant, being able to take 4.5% increasing to 5.5%, is huge, and for it to stack up in over 7 of every 10 scenarios, with a very conservative portfolio, massive!
In addition, the worst case scenario in all of history of reliable data, was that you ran out in your 87th year, over 20 years in! How, I hear you ask……Spending Guardrails of course!
What Is The Spending Guardrail Strategy:
First thing I will say is that it might seem a little convoluted when you hear this for the first time, but trust me it’s not really. Like many of these things however it is fairly simple in theory, the practical application is less simple, particularly given the Revenue ARF rules that apply in Ireland. Having said that, as someone who works with clients to deliver this strategy, it is totally workable once it is managed effectively, once everyone is committed to sticking to it, and when it’s done right!
The whole premise of Guardrails is that you commit to maintaining flexibility with your spending, and it is that flexibility that enables the significant improvements in the longevity of your retirement pot. You will increase your spending when the income you are currently taking from your pot falls below a certain % of your current pot value. Likewise you will decrease your spending when the % income you are currently taking from your pot exceeds a certain % of your current pot value. Due to the fact that in Ireland we are obliged to take a minimum of 4%/5%, the level of flex is driven by the fluctuations in your pot value.
In the above scenario we started off aggressive by drawing 4.5%. We committed to increasing our spending if our current withdrawal rate fell by 10% or more on each anniversary. We committed to decreasing our spending rate if our current withdrawal rate increased by 10% or more on each anniversary. Let me explain.
We start the above strategy in January 2019, drawing our 4.5% (€45,000) from our €1m pot. When we review our strategy two years later in Jan 2021, we find that our pot value, even after taking our €90,000 (2 years income), is now valued at €1,120,000. We can now see that by taking €45,450 next year (we got a 1% increase in line with inflation!) from a pot of €1,120,000 our withdrawal rate for this year will be 4.06%. We therefore follow our strategy and increase our income, in this instance by 10%, to €49,995.
Important to note you can set the limits and increases to suit your overall strategy, with any number of different permutations and combinations to deliver the optimum result for you. This is best agreed to and designed at the outset, and everyone committing to it. That is of course unless under review it transpires it is definitely not working from a standard of living perspective, and can then be altered.
On the flip-side, what about when portfolio values temporarily decline, which we fully expect and accept they will – it is is part and parcel of our strategy of course! Same over-arching strategy here, except in reverse. Lets imagine we are reviewing our strategy in Jan 2021. We have taken the €90,000 over the past 2 years from our pot, the pot value is in temporary decline, standing at €850,000. Again, inflation adjusted intended income for 2021 is €45,450. That actually represents 5.34% of our pot value, which is more than a 10% increase from 4.5% so we therefore take a spending cut for 2021 of 10%, reducing our income to €40,905 for the year ahead.
Do this each and every year, once per year, and you can give yourself a significantly better probability of long term retirement income success! Sure there will be pain in the negative years where our withdrawal rate spikes, you’d expect that to happen approx every 5th year or so based on averages. In addition you could potentially set some of the income from ‘bumper’ years to balance out your spending over leaner periods. And therein lies the biggest draw-back of the Guardrail strategy, you will inevitably have to reduce your income from your pot. Some people would simply not be able to afford, or will be unwilling to do this. It is the major draw-back of the Guardrail strategy. As with all things in life, you can’t have your cake and eat it, here you sacrifice some income in order to improve your chances of success and perhaps take on less volatility.
Should I Invest In Bonds In Order To Avoid Volatility?
You could argue that having a sizable portion of Bonds in your portfolio could smooth the returns (and lessen them!). You could argue that if adopting the above strategy you might prefer to reduce the number of years where you have to reduce spending. Valid desires for sure. When I put a spending ‘Floor’ into the above scenario to specify that we are not going to take any less than €40,000 from our pot in any year over our retirement it reduces the probability of success of this strategy to 69%. While still a lot better than 40% it shows that with this strategy there will be pain in the form of reduced income. It just boils down to whether you want to take that or not.
As we know, Bonds have delivered well less than half of the long term average returns that equities over the past 100-odd years of market data. So I will continue to question the logic for a large % of them in one’s multi-decade income-generating portfolio. Just for fun I tweaked the portfolio to one of 100% Equity. I chose a carefully selected blend of globally diversified equity indices and immediately the data shows our probability of success of the above strategy jumps to 94%, and that is including that spending ‘Floor’ of €40,000.
But hey, Equities are risky…..right????
Oh, if you need a tool to help you consider your retirement income needs then a good place to start would be here at CCPC’s website and their Budget Planner tool, might be of use to you I hope.
Any feedback, ideas, thoughts or questions drop me a mail here. If you’d like to explore working with me on your own investment and retirement income planning I’d be delighted if you read the ‘Work With Paddy‘ page to see if we might be a good fit for you.
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