Defining and evidencing Sustainable Withdrawal rates

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:

1. 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.
2. 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.

Fees and charges - Full costs need to be included; platform fees, fund charges and adviser fees.

Probability of success – This defines the desired probability of successful outcome for each income stream.

If we imagine these controls as dials, and set them in different positions, we get different SWR figures aligned to the respective income stream. This is what we start with:

If for example we looked at essential spending, it could look like this:

The timescale covers expected longevity, with income adjusted for inflation. Fees are included, and the high probability of delivering the income reflects the security required. The portfolio mix allows for use of secure or guaranteed assets to be included alongside equities. This could produce an example rate of 2.4%.

For the discretionary spending, we re-set the dials:

Now we have a different timescale. For the sake of argument, if the client was 65, then a 20 year period could reflect their more active years. The probability of successful outcome is lower to reflect the reduced importance of this income.

The final step is to calculate the capital to support the income levels needed at the defined sustainable withdrawal rates. Advisers will then need to steer clients through the decisions needed depending on whether they have sufficient funds.

One other point to consider is the use of a Withdrawal Policy Statement. It is worthwhile using this to record how the SWR was arrived at. These can set out the reasons agreed with the client including what could impact the withdrawals, how the income will be sourced and frequency of reviews. Various providers offer templates for these are worth seeking out and using. 

Summary

The importance of proving sustainability has been brought to the fore with the dissolution of income benchmarking using critical yields at review, regulatory safeguards and the absence of GAD limits on flexi-access drawdown. Pre freedoms, it might be argued that GAD limits were a restriction of freedoms, but provided a safety net to ensure funds couldn’t be exhausted. Now the individual has ownership of all the risks, rather than the insurance provider.

This is where advisers can help clients enjoy a tailored retirement income and not run out of money.

Achieving this could involve using a wider selection of products. A combination of guaranteed income for life, provided by an annuity, DB pension, or state pension along with investment, or property wealth, could give the right balance of income needed.

Evidencing a Sustainable Withdrawal Rate is just one part of managing a client’s retirement funds. Developing a de-risked decumulation strategy that’s robust and repeatable is worth considering as there could well be a tsunami of retirement clients just waiting to switch income on. This is heading our way, and advisers need to be ready.

Tony Clark, Proposition Marketing Manager.

Read our new Think report ‘Defining and evidencing Sustainable Withdrawal Rates.’

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