Pensions  

Past performance leads to drawdown misconceptions

Past performance leads to drawdown misconceptions

The past success of US equities and a post-crisis environment of lower market returns have contributed to “dangerous” misconceptions regarding average annual drawdown rates, according to Morningstar.

The firm said 4 per cent has been seen as a safe initial withdrawal amount, enabling investors to take income in retirement without running too high a risk of exhausting their savings too soon.

However, a report from the ratings agency has suggested the figure should be closer to 2.5 per cent for UK retirees.

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Morningstar said the 4 per cent figure, which stemmed from research conducted in the US in 1994, was no longer applicable and gave UK investors a false sense of security.

Dan Kemp, chief investment officer for Morningstar’s investment management group Emea, said: “Most studies on the topic have been conducted for US investors using US data, and it was dangerous to leave this assumption unchecked given the greater number of UK retirees who must now familiarise themselves with the concept of safe withdrawal rates in light of the pension freedom rules.”

The findings have implications for the typical portfolio size required by investors upon retirement.

Based on a 2.5 per cent annual drawdown, Morningstar said retirees would need a portfolio 40 times larger than their desired annual income. This compares to 25 times at the 4 per cent figure.

The ratings agency said: “The generous capital market returns of the prior century that bolstered a comfortable and long-lasting retirement portfolio may give 21st-century retirees a false sense of security.

“Long-term returns for most capital markets are estimated to be lower than observed in the last century. This is particularly the case within equities where above-average valuations in many markets have diminished future return expectations. Interest-generating assets are also being affected by lower prevailing market yields.”

In its analysis, Morningstar said safe withdrawal rates varied by country, meaning the 4 per cent figure based on US returns was not sensible for domestic investors. Historic returns in the US, which played a significant factor in the assumption, were the highest among a 20-country sample.

Based on a 90 per cent success ratio, the safe withdrawal rate for US retirees was 3.6 per cent, compared to the average of 2.3 per cent.

Morningstar said the average length of retirement, which has increased due to retirees living longer, was another reason for the rate to be lowered.

Its analysis showed that for a 30-year retirement, a portfolio with 40 per cent exposure to equities would require a withdrawal rate of just 2.1 per cent to ensure a 99 per cent chance that savings would last for the whole period.

Mr Kemp added: “The investment industry has long referred to a safe withdrawal rate of 4 per cent and we were concerned to know if this is a reasonable assumption. The investment returns of the last century are no longer with us. Clients and their advisers need to set realistic return expectations.”