There has been a lot written on Safe Withdrawal Rates already. I read a book by Abraham Okusanya called “Beyond the 4% Rule” (ISBN: 978-1985721647). Most interesting. Then there is the extensive online work by ERN which I do commend for anyone just wanting to grasp a lot of the concepts, limitations and variables involved.
I am not going to comment on the 4% rule per say, but Abraham Okusanya rather points to a SWR of 3.3% in the UK as USA returns have historically been higher. Its an interesting read exploring different rules or strategies to vary the SWR depending on investment performance.
In any case, it is just numbers and put in what you will. The basic tenet however is the initial rate used is based essentially on a 30 year draw-down period. ERN’s work demonstrates that unless you suffer badly from initial sequence risk (go read, it is simpler), then there is a strong probability that you will not run out of capital, and this ties very much with the wider body of work.
I do however caution my own view that much of the historic and recent published work uses a lot of historic data. The world we live in now has lower returns, higher volatility and we are awash with printed Quantitative Easing money depressing the Bond and capital markets … as always DYOR and come to your own views
So what was the thought that crossed my mind ?
The whole premise of an initial SWR is picking a value that gives a high probability of not running out of money (and has a bi-product of a good probability of maintaining capital). It can be a fixed amount, an amount that increases over time etc, but the one thing missing, at least in my future scenario and I guess in many peoples, is the step points in time where we know ether outgoings will significantly alter, or other income streams become available. Now don’t get it wrong, using an initial 4% or 3.3% and basing an entire retirement on that will very probably work just fine, but if outgoings will drop and other income streams come online, then surely the initial fund size does not need to be as large….. so could we retire earlier ?
Rounding a lot for simplicity of example, my current outgoings are £50K. Earlier in the year I considered what we need and came to the conclusion that a very modest retirement was circa £20K and a good one circa £40K (all the holidays, dining out visits, full social life etc), both excluding mortgage. Nothing much has changed substantively, but if I just add a small margin and use £50K, my wife already gets a small pension so in reality we need £43k. ON the face of it £1.3M using 3.3%.
So far so good….
However, in that outgoing is a mortgage that will complete in 6 years time (if I choose not to pay off early). Rounded numbers and the figure needed each full year is £10K.
So if the mortgage was excluded I would need £1M instead. Using the same 3.3%
Anomaly no. 1
I apparently need an additional fund of £300K to pay an outstanding balance of £65K … ridiculous !
In UK pension rules say I can take money out tax free to a limit of 25% of whatever my calculated allowance is. In my case it is £1.05M, so I can essentially take around £250K tax free if I move £1.05M into DrawDown.
I could, for example, take around £65K of that and set up a bond ladder to pay off the mortgage (so long as the bond returns better than 1.41% which is my effective mortgage rate, I don’t loose anything and maintain control of capital. I had a look at Gilt ladders earlier this year. This would leave around £185K in free cash to spend or save however we felt … nice !
Now I have not entirely decided on taking the tax free lump as another option is to transfer and then take 25% out of the Drawdown off each disbursement tax free. My worry is that Governments like to change rules, and whilst messing about with big insurance structures tends to be difficult and resisted by the very powerful financial industry, little private souls who do it themselves are fair game. So will probably take the tax free lump.
Outgoing needed (ex mortgage) (£40,000)
Net Income (wife pension) £7,000
net required £33,000
Using 3.3% that comes to £1M – honestly .. an accident.. not a round number fix 🙂
Using the SWR of 3.3% and assuming I need £33K pa from my pension, a fund of £1M is needed….. right ?
Anomaly no. 2
One of the things that rarely seems to be discussed in SWR material is taxation. The assumption being the fund is essentially free of tax. I am not that familiar with US 401K type funds so maybe they are tax free, I don’t know and since much of the material comes from across the pond, that seems likely to me. But no matter – tax matters !
From my pension fund, income drawn is taxable, so the gross figure (using today’s tax allowance numbers of £12,500 and the basic tax rate of 20%) would be:
Net = Gross – (gross – allowance)* 20%
Gross = (Net + 0.2* Allowance)
So to get £33K, I need to take a Gross sum of £38,125. This implies a fund required of £155K more at £1.155M., or to put in a wider rule of thumb perhaps, approximately 15-16% more. That is a lot we give to the taxman !
So how about a Rule of Thumb for the SWR followers …
When doing your withdrawal calculations … DON’T forget the implication of tax
Looking at a couple of possibilities:
1. Just just calculating fund size based on 30x Gross income needed (3.3%) each year for the first 10 years, 20x for the next and then 15x after that as we will have less time left and therefore less need.
2. Just a simple No of years left x Gross required that year.
I get a couple of lines not too dissimilar (which did slightly surprise me). Does rather show that using an initial point of 30x initial needs and then applying a sensible scaling factor has a certain validity to it.
Well… so far so good, but what I have really done is look at the initial point (like much of the SWR rate material). There are however, other things to consider:
At the age of 67 (here in the UK), both my wife and I get state pensions [Note this varies depending on when you were born, so for us it is 67, for others it is earlier and anyone under 45 can expect it to be 68+ in future]. No a massive amount and just for simplicity I am going to assume it is fully taxed at the basic rate [not always the case but for simplicity just assume it]. Rounding and adjusted for inflation that would give around £17K net.
So at 55 years old I look at a 30 year SWR period taking us to 85. A good age and who knows, we my get there ! But at 67 years, we only have 18 years left, so surely I need a much smaller fund at that time as it has to last a lot less, and as we get our index linked state pensions we need to draw less.
There are some academic articles I have read (wish I had made a reference note now) and some data on UK ONS (Office for National Statistics) site that shows spending drops with age, in some categories by a few percent, but others, like recreation, by around 50% by the time we get to 75.
It is fair to say that we could assume a reduction in outgoings from the age of 70 by at least inflation (ie not factoring an annual rise) very safely – just a thought. Right now that complicates so for now, just assuming outgoing increase with inflation each year.
I could take a view that I recompute the fund size based on say 18 or 20X requirements at the time in the same way I started at 30x requirements.After all, I can see from the graph above that is not unreasonable. If I did that at 67 my requirements in this model says £26,679 Gross. So 20X means I need a fund of £533K. (Note that this assumes an effective drawdown and does not include any effects of return on the fund)
But would I be leaving myself open to a sequence risk ?
I would hope not as I do intend by that age to have very conservative, income and bond based investments, but sequence risk is a risk to consider for sure. Also, my outgoings will go up with inflation. However, this will be offset by the index linked gold plated income and the very real natural reduction in outgoings that comes with age. In a similar way that there is evidence as I said above of cognitive fall-off with age, so there is evidence of reduced outgoings. It is self evident that we won’t travel quite as much, or do quite as much, and may well have downsized to a smaller house with reduced running costs.
Still, using the ‘standard’ SWR method, my start fund was £1,155M and now 12/13 years on I need £553k…. that is a reduction of £622K !
… where did that money go ?
Well, no-where, it is just a computed requirement. In fact the total I would have taken out (gross) would be £579K in that time in my model, Reality of course might well be different in both the case where I get very good or very poor returns.
In other words, my fund could loose £43K over 12 years in real terms (approximately) and I would still be on track. That works out at an approximate negative return of 0.3 -0.4% each year in real terms.
REALLY ! I could get a negative return and still make the numbers ? .. wow it is all after all just numbers !
I would say that is good built in resilience based entirely on a reduced need that I can essentially guarantee in the future. The SWR series of both articles and research all point to the requirement of good periods of positive returns, but they are based on a fixed or known rate of income increase.The very detailed article series ERN has produced really emphasise the analytics needed, the statistics and the impact of many variables – all things we must consider for ourselves.
But by considering the staged requirements of life as a result of retiring early, I can not only take a solid start point view, but also add in a level of inherent resilience to the model and adjust my investment strategy if I choose to be even more cautious and still make the numbers.
So understanding future income need alongside future income guarantees can allow me to de-risk further.
Just to be clear though, this does assume the effective drawdown of funds and not passing much on. If you need to do that then you may have a higher level to start with. Let us remember that the SWR series of calcs does rather demonstrate that in around 5% of cases would you run out of money and in 75%+ of cases you essentially never run out. In the majority of cases a tidy sum remains to be passed on so not all doom & gloom. Also, consider you may well live beyond the 30 years period !
But if my pension fund was only £1.155M (after taking my £250K lump) and I was in that 5% bracket and I essentially ran out of funds somewhere around 85 years+, what then ?
Well, almost everyone who is really looking at FiRE has a plan for multiple pots. I have just considered my pension fund. But we do have tax free funds currently these sit at about £220K.I had expected to both grow, add to and draw out of these funds over time as part of retirement. I know I will add a good chunk (remember I have around £185K of the tax free element out of my taxable SIPP). Under our tax rules I can only add £20K to each of our funds a year, so assuming some play money, that is 4 years to add £160K. If I assume a 3% return (ie inflation + 1%) then I end up at 85 with around £900K using a simple model.
By assuming a plan to draw down my taxable SIPP, ignore the effects of reduced income needs to add resilience, I can still end up with funds in excess of £1M and most of it will be outside of tax.
Is this all really a bit Academic ? After all, it is a contrived example that assumes:
1. The initial fund returns are neutral or (as shown above) a little negative and is essentially just drawn down. This is possible because the drawdown requirements reduce various points.
2. Returns utterly ignore one of the basic income streams of a fund, yield
So if I re-compute using a fixed return and 2% for yield:
- With an annual growth of 1.5%, I get an annualised growth of 0.4% and a fund of £1.4M
- With an annual growth of 0%, I get a fund of £793K
- With an annual growth of (3.0%), I get an annualised growth of (0.8%) and a fund of £161K
… and a spread in-between
So here is an interesting thought. If I assume a (1.0%) loss every year, ie, inflation minus 1% in real terms, my start fund requirement drops to around £800K from £1.155M (£355K less). Perfectly possible with a bond structure and in a simple way, this is how annuities make a shed load of money for the insurers over time.
Applying a bit of randomness and just running a basic simulation where the yield is fixed at 2% of whatever the fund is and the growth is nominally a normal distribution of 0% with a peak of +/-10% possible [(rand()-0.5)/10] and start with my new (albeit higher risk point) start of £800K, apply my know income profile I get the following graph on a handful of runs:
So just visually and not empirically, it looks like an average fund left of circa £350K.Doing the same with a start point of £1.155M I end up with an average fund knocking around £800K
The power of compounding and dividends at work – and if I get a sequence issue I can use my ISA cash bucket !
So back to my original question.
What I wanted to consider was the effect of two known points in my future, and whether I could use that to reduce my initial fund assumption.
The first was paying off my mortgage and essentially the best plan seems to be to draw some tax free cash and put to one side in a bond or CD ladder to pay off. The second was the state pension event where our index linked income will rise fairly significantly (in a sense that it would cover pretty well all household costs). The third but lesser event is to realise and include at some point is that our outgoings will naturally reduce after 70 for the most part.
So things to consider as on top of a basic ‘what is the initial fund I need’ question:
1. The skewing effect of any early and fixed time big outgoing needs (like a Mortgage)
2. Tax – Make sure you include tax in the calculation – far too much SWR stuff talks about absolutes, not what it takes to generate that.
3. Plan to leave Tax-Free funds alone … then Governments cannot get it off you and it hedges naturally should you actually run out of funds with poor sequence risk or bad investments.
4. An initial assumption of a low or negative annual growth of funds, coupled with a modest yield could lead us to consider a lower start point just be clear on the risk and have alternate non-taxable funds building to hedge.
5. Using a more ‘standard’ SWR approach of an initial fund need I automatically build in both resilience and the overwhelming probability of never running out using my variably reducing income profile each persons profile will be different though.
6. Using what looks like around 70% of the fund needed using (5), gives me a good probability of not running out of money, but does tend to not passing much on. So earlier retirement, or considering a slightly more modest one are real possibilities FiRE is about options !
A bit of a walk through and I had gotten to the point where I was thinking a fund of £1.5M+ was needed earlier this year, but actually, with a bit of careful structuring and some clear break points I have come to the conclusion that although not half, I do need rather less as an initial point. Given my pension funds are above this I have a very comfortable feeling about the next 30 odd years now.
In the end, it is for each of us to work through and understand our particular requirements. It is not difficult maths and is all about understanding the what-if’s
Who would have though a simple question could take me on a bit of a wander through what I actually need and when I actually need it – something to consider !