Sustainable withdrawal rates (SWR) have become a core advice issue for advisers with retirement clients, especially following the shift from annuities to drawdown, post pension freedoms.
It’s understandable; the retiree is not only choosing freedom and flexibility, but also accepting liability for longevity risk, which means ensuring any income taken won’t exhaust their capital.
When a client decides to switch income on, risks are turned on their head. The adviser has to keep many plates spinning; pound cost ravaging, sequencing risk, and capacity for loss all have to be considered in helping a client safely withdraw money from their drawdown pot.
There are many methods for articulating what the SWR could be, but how is this evidenced? How do you put a consistent, robust and repeatable approach in place when everyone’s needs are different?
A de-risked decumulation strategy
Decumulation is a very different environment to accumulation, and as such requires a different strategy.
As well as the various different risks mentioned above, there is a need to manage income volatility as well as capital preservation. This is a very different set of objectives.
For adviser and client alike there is a fine line between draining capital, and generating a sustainable regular income.
Ironically, in this age of pension freedoms, generating sustainable income requires controls in place. Many advisers are considering a Centralised Retirement Proposition (CRP) for this purpose.
There is debate around what constitutes a CRP; one way to describe it is as a de-risked decumulation strategy, deploying measures to manage the different aspects of decumulation. Many advisers are already using a Centralised Investment Proposition (CIP), and with a few refinements can apply it to decumulation.
Of course, every firm’s strategy will be specific to their business model, but at its core is the ability to articulate and evidence the moving parts of a sustainable withdrawal rate.
Evidencing sustainable withdrawal rates
There have been many research papers in recent years looking at finding the elusive ‘magic number’, with figures ranging from 2.5% to 4%.
The issue though seems to be where any assumptions start, which is with the individual, not the mass market.
Every client will have their own requirements, savings, liabilities, and views on what risks are acceptable. It will be different for everyone, and so everyone will have their own SWR.
There are two elements to defining and evidencing sustainable withdrawal rates:
- Define income needs split between essential and discretionary spending. The client will have ongoing lifetime costs, and separately require money for the more leisurely aspects of retirement.
- Understand and establish the ‘controls’. There are several moving parts that define the SWR for each income stream.
The first stage is simple budget planning. Once this exercise is carried out the next stage is to consider the ‘controls’; these drive the inputs into the adviser’s stochastic modelling software, which can be (but not limited to) typically:
Time horizon – How long is the income needed for?
Inflation assumptions – Linking to CPI/RPI maintains purchasing power over time.
Portfolio asset allocation - This considers the equity exposure that is supporting the income stream. This reflects the purpose of the income and risk capacity available. For essential expenditure, guarantees may be required, whereas for discretionary, a higher risk tolerance could be sustained.