Pensions  

Does the 4% rule work?

Kevin Doran

Kevin Doran

In a room full of professional advisers, there are a few phrases and topics that can be relied upon to get the conversation started. 

I would call them room-splitters. 

Innocuous questions like: "Active or Passive?" or "Network or not?" will have the tribes forming faster than you can say "Brexit", but in among these financial shibboleths is undoubtedly the good old "4 per cent rule".

In the days when annuities ruled, there was little need to spark up a chat with clients on longevity risk. 

That problem sat with the life companies. 

For their part, such was the complexity of insuring and ensuring that customers had an income for the rest of their lives, they recruited armies of actuaries to help them untangle the knot. 

Understanding longevity and making sense of the calculations is not easy.

But in a world of pension freedoms and more customers entering into drawdown, understand it we must.  And not just us. 

We also have to be able to convey the risk to clients. 

Given the number of variables involved: expected life, withdrawal rates, inflation, spending patterns, investment returns (and the order in which they are witnessed) the chances of having a proper discussion about this with a client are pretty slim. 

That is where the 4 per cent rule can come in handy.

It is not a silver bullet. 

Far from it. 

I am yet to meet an adviser who uses it in isolation without pointing out the pros and cons, but it is a useful jumping off point, especially when backed up with the use of cash flow forecasting software such as CashCalc, Voyant or our friend Abraham’s Timeline App.

If Abe was penning this piece, he would no doubt (in ways more eloquent than I could ever) demonstrate that the best strategy to follow for drawdown clients is to take as much equity risk as you can bear, set a flexible, but structured withdrawal policy and tough out the years when investment returns are inevitably tough. 

And he would be right. At least statistically.

But designing investment products and services requires more than just statistics and theory. 

Despite advances in artificial intelligence, financial services are bought by humans, not robots and so it is important to build a human element into their design.

To this end, the FCA commissioned the Financial Advice Working Group to develop useful rules of thumb and ‘nudges’ for UK consumers. 

Similarly so, the regulator encourages product designers to consider behavioural aspects when developing new services.

It was with these aspects in mind that we launched our Retirement Portfolio Service with reference to the 4 per cent rule. 

Sure, we know it is not perfect. 

We know the world is more nuanced and every customer is different, but it is a useful rule of thumb to have in the toolkit and one that we know is used extensively by advisers up and down the land.