Personal Pension  

Calculating pension income

    CPD
    Approx.30min

    As pensioners face the retirement challenge, their biggest fear – understandably – is running out of money. Pension freedoms are nearly upon us, and advisers will need to come up with solutions for their retiring clients, recommending investment portfolios that enable clients to draw an income over a lifetime with confidence.

    To achieve the best results, existing thinking and rules should be challenged. One way of approaching the problem is to calculate a ‘sustainable withdrawal rate’, that is, the amount that clients can draw down from their portfolio with a minimal risk of running out of money. We have analysed the effects of using different investment strategies on this rate.

    Our results show that a key to creating a sustainable retirement income and overcoming the fear of running out of money in retirement is rooted in the effective management of two of the fundamental risks facing pensioners: market risk and inflation risk. Additionally, we found that managing these risks using modern risk management techniques, which are now available to retail investors, may lead to an increased sustainable withdrawal rate, while maintaining the same risk level as more traditional approaches.

    As a result we have arrived at two general ‘rules’:

    1. The 4 per cent rule: A rule of thumb based on the 1994 paper of that name by William Bengen. This rule flows from a traditional approach to generating income and managing risk by means of a fixed allocation to equities and a sizeable allocation to fixed-income assets.

    2. The 6 per cent rule: This rule follows an alternative approach to generating income and managing risk using equities with a dynamic risk management overlay.

    To come up with these rules and to test alternative asset allocations, we developed a stochastic (that is, probability-based) model which accounted for external risks as well as a client’s profile – for example, age, gender or attitude to risk. The model calculates the sustainable withdrawal rate for various scenarios. To do this, the model estimates the probability of financial returns from over 1,000 generated real-world market scenarios, each containing a minimum of 30 years of daily returns for indices and interest rates. The assets’ annual growth rates are calculated as a result of the asset allocation, and are reduced by two factors: the impact of adverse market conditions and the sequence-of-returns effect. These adjustments are critical to ensure that the resulting ‘return for planning purposes’ takes consideration of market risk, and provides a sound basis from which to determine the sustainable withdrawal rate. The model has been developed using US data, but the message is very clear for all markets.

    To illustrate, let us use the example of a 65-year-old man who has just retired. He has a moderately conservative attitude to risk, and would like a high probability that his money won’t run out over the planned period – which we have quantified as a 93-96 per cent confidence level. Figure 1 assumes that his money will be split between 65 per cent equities and 35 per cent fixed income, which is quite a traditional approach.