One of the most important factors in retirement planning is the “safe withdrawal rate”. This is a formula which tells you how much you can take out of your savings and investments in the first year of retirement, then increase that amount with inflation every year, without there being any risk of exhausting your funds during a thirty year retirement.
The “safe withdrawal rate” was originally calculated, based on the worst case historical scenario, so, if your initial withdrawal didn’t exceed the safe rate, you would know that you still wouldn’t run out of money if, during your retirement, you experienced a repeat of the first world war, the 1930s depression, the second world war or the high inflation of the 1970s and 1980s. In the UK, the safe withdrawal rate has been around 3.25%, taking account of charges and tax (the oft-quoted “4% rule” only works for Americans and ignores tax and charges).
New research has been produced by Morningstar, which takes a slightly different approach, and provides some additional insights. Their approach has been to combine historical factors with some sensible assumptions about what might happen in the future. They have produced figures showing how the safe withdrawal rate might vary, based on the values of shares, fixed interest stock and other investment assets.
Morningstar’s logic is that the value of shares, in particular, goes up and down a lot. So, if you had retired in 2007, just before the Global Financial Crisis, your portfolio would have suffered an immediate setback. Your experience would be different to somebody who retired in April 2009 (shares increased in value by 40% in the year following 1st April 2009). Morningstar suggest that the person who retired in April 2009 should have a much higher “safe withdrawal rate” than the person who retired in 2007, and this makes sense.
Morningstar’s approach tries to predict where financial markets are and combines this with historical data, to work out if the safe rate can be increased. They have been doing this for a few years now – at the end of 2022, they predicted that the safe rate was 15% higher than it was in 2021 (shares fell in value during 2022). It then increased by another 5% in 2023 (shares increased in value in 2023).
During 2024, most investment assets increased in value, so it is logical that the safe rate should reduce, as a larger proportion of the long term returns were experienced during 2024 than expected, and, maybe, a setback for asset prices is more likely; Morningstar have suggested that the safe rate is now 7.5% lower than it was last year.
Morningstar’s research gives us some other useful information too.
The standard figures, which Morningstar produce, are based on the amount of the withdrawal increasing every year, in line with inflation. Research has shown that retirees spending doesn’t increase in line with inflation – in general terms, it tends to lag inflation, as people become gradually less active as time goes by. If you are prepared to accept that your withdrawals will lag inflation, this has a big impact on the starting withdrawal rate – potentially increasing it by almost 30%.
Morningstar also suggest that you can increase the amount you withdraw in year one, if you are able to tolerate some variation (downwards) in the amount of money you withdraw from your portfolio in some years – after a fall in asset prices. Using this approach could increase the initial safe rate by around 10%.
If Morningstar’s research is correct, the cost of retirement has increased during 2024. However, hopefully, your portfolio value will also have increased, and the increase in the portfolio value might have made up for this cost (but not necessarily – it will depend upon the make up of your portfolio and how much you were intending to add to it during 2024).
However, we do have to take this all with a pinch of the usual, American, salt. Morningstar is a US based company, and its figures use US inflation and investment returns data. As most UK investors enjoyed higher than expected returns in 2024, the cost of retirement in the UK will have increased too.
It isn’t a good idea to rely on “rules of thumb” for something as important as your standard of living in retirement. If you would like us to help you work how large your portfolio should be, in order to have the lifestyle you would like when you stop work, please contact us.
The original Morningstar report is available in full at https://www.morningstar.com/lp/the-state-of-retirement-income
Philip Wise | philip@sussexretirement.co.uk
Managing Director and Chartered Financial Planner
This blog is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The favourable tax treatment of ISAs may be subject to changes in legislation in the future.
