A colleague in Japan has sent me Morningstar’s research on sustainable withdrawal rates for the Japanese market. It is a rework of the analysis it did for the UK market a couple of years ago and I am sure it will be applying it to other markets soon if it has not already done so.
It is a decent piece of research but, as I read it, I am reminded how uncomfortable I am with the idea of sustainable withdrawal rates altogether. I have not yet got as far into the maths as others but there are some more fundamental challenges I have with the concept.
I am getting more worried about these as we learn the FCA is becoming more focused on the drawdown market and, in particular, how we talk to our clients about sustainability.
The landscape has shifted
First, we see few customers looking to just take regular income for a lifetime. It is generally accepted (though perhaps not well researched) that people have a greater need for money earlier in their retirement. As they get older and less active, the need for cash reduces but may increase later in life as care costs need to be funded.
This suggests a reverse-J or U-shaped income requirement rather than the gradually increasing linear requirement sustainable withdrawal rates tend to assume. Essential expenses may have this shape but, in many cases, these will be (or should be) covered by guaranteed income.
In fact, pension freedoms mean many are not looking for any sort of regular income, preferring to withdraw lump sums on an ad hoc basis or even take nothing at all. Again, this makes the idea of a sustainable withdrawal rate much less relevant.
But let us assume we are faced with a client who is looking to use an investment portfolio to provide a growing income for life. What relevance does the sustainable withdrawal rate have here? On paper, it seems to make sense but what concerns me is how taking the sustainable withdrawal rate at face value might lead to an overly conservative approach that will have clients missing out on the retirement they saved so hard for.
Pension freedoms mean many are not looking for any sort of regular income, preferring to withdraw lump sums on an ad hoc basis or even take nothing at all.
In it for the long run?
Many sustainable withdrawal rates will be calculated at 90 per cent or 95 per cent confidence. But what does 90 per cent confidence mean? The positive interpretation is that there is only a one in 10 chance of the client running out of money before they die.
That is great but flip it around and we conclude there is a nine in 10 chance that when they die there will still be money left in their pension pot. In many cases, this will be a non-trivial amount and, in some scenarios, the client will actually have more in their pot when they die than when they started.
Some may say this is no bad thing but I would argue it is. Every pound left in my pension pot on death is a pound I did not get to spend while I was alive. My heirs might be grateful but if it means I did not get the retirement I wanted, then I would say it is a bad outcome. What is the point of saving all your life, only to be too afraid to spend it in retirement?
The usual response to this challenge is to say people can reassess their income and increase it if the markets do well. They can but then this just gives them even more income in later life when we have established that, in most cases, they are likely to need less.
In addition, this approach still leaves a lot on the table as it is always aiming for a high level of confidence that the money will not run out over the rest of the client’s lifetime.
Every pound left in my pension pot on death is a pound I did not get to spend while I was alive.
In summary, then: using sustainable withdrawal rates in practice reduces the risk of not running out of money in retirement but increases the risk of not getting the most from your retirement. While they provide a useful benchmark, it seems we need to consider more practical approaches to managing income in retirement.
At the heart of this is building withdrawal strategies that are managed dynamically, adjusting income and asset allocation as market conditions develop. This might allow us to start with a lower confidence level but with the understanding that, if markets failed to deliver, then the “cost” of this would be reduced income in the future.
The adviser and client can work together to decide what balance needs to be struck between maximising certainty and maximising income. Those who can be more flexible in their income requirements can aim for higher initial withdrawals. Those who need more certainty will have to accept lower initial income levels.
This is the reality of drawdown. Aiming for safety by setting a very conservative withdrawal rate will mean people do not get the retirement they saved for. By accepting the risk of having to take a reduced income if markets fall, then drawdown can be made much more efficient. And if clients cannot accept that risk, maybe they should not be in drawdown at all.
Richard Parkin is head of pensions policy at Fidelity International