In my previous posts, I have explained sequence risk (or Pound:Cost Ravaging) and how it might affect you.
This week, I’ll explain the first essential step towards reducing the impact of sequence risk.
Your Personal Withdrawal Rates
The first essential step to reduce the impact of sequence risk has nothing to do with investments at all.
A withdrawal rate is the amount you need to withdraw from your portfolio every year, divided by the value of that portfolio. So, if you have an investment portfolio of £500,000, and you withdraw £15,000 per year from it, your withdrawal rate is 3%.
What is a Sensible Withdrawal Rate?
Before you can set a sensible withdrawal rate, you need to follow these steps:
- First, analyse your expenditure, dividing it into essential (e.g. council tax) and discretionary items (e.g. holidays and eating out).
- Next, divide your income into two elements – guaranteed and investment-linked. Guaranteed income includes items such as state pensions and pension payments from final salary schemes.
- Then, subtract your essential spending from your after tax guaranteed income.
For many people, the guaranteed income will be more than their essential expenditure. But, if there is a shortfall, you will need to use some of your retirement savings to cover your essential expenditure.
Once you have analysed your income and expenditure, you should calculate a sensible withdrawal rate for the two types of expenditure (essential and discretionary). A higher withdrawal rate can be applied to discretionary expenditure than to essential expenditure – after all, if you had to reduce your discretionary spending, this would not be catastrophic, but you won’t be able to reduce your essential expenditure without taking drastic action. Typically, you can increase your sensible withdrawal rate by 0.5% per year if the money is needed for discretionary items (and you can therefore afford to reduce withdrawals following bad investment years).
It is also important to recognise that your withdrawal rate should be linked to your life expectancy. It stands to reason that a 95 year old can withdraw a higher percentage of their portfolio every year than a 65 year old, as the capital doesn’t have to last as long. Longevity also multiplies other risks – e.g. it is much more likely that a stock market crash, or some other spending shock, will take place in the lifetime of a 65 year old than in the lifetime of a 95 year old.
Technology to the Rescue!
Setting a withdrawal rate isn’t simple, but, in the last couple of years, technology has evolved and given us the ability to set withdrawal rates on an individual basis. As a result, you don’t have to rely on “rules of thumb” and other guesses – you can make your estimates more accurate and reduce the risk that you might outlive your money.
The withdrawal rate needs to take account of your views about investment risk, the types of investments and assets you hold, your tax position, and the amount you pay in charges, as well as life expectancy and what the money is being spent on.
We use a programme called Timeline to help us do this, and any good retirement income adviser will be using Timeline or something similar. Timeline helps us to tell you how likely it is that your withdrawal rate can be sustained throughout your lifetime, or to put it another way, how likely it is that you will run out of money. It does this by looking back at 100 years of data and making sensible assumptions about the future.
Next week, I’ll look at how you can reduce the impact of sequence risk on your portfolio.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner