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Sequencing risk can be safely managed

Sequencing risk can be safely managed

For many years there has been a discussion around the ‘safe withdrawal rate’.

By this we mean the rate at which an investor can erode their capital (for income in retirement, for example) at a ‘safe’ pace.

That is to say, the funds should not run out before the longevity of the individual does.

In 1994, US financial adviser William P. Bengen first articulated the idea of using 4 per cent of starting capital as the ‘safe withdrawal rate’.

However, a lot has changed since 1994 so we will review to see whether this general rule of thumb still applies in today’s world.

What affects the withdrawal rate?

There are several factors that affect the withdrawal rate that advisers and clients may wish to consider, as follows:

  • The age at which someone retires (or starts drawing on their funds)
  • Inflation and the subsequent need to increase withdrawals (in notional £ terms) over time
  • Volatility of the investments in the portfolio
  • Tax – that is, how much of the fund has to be eroded (gross) to give the client their (net) retirement income?

The safe withdrawal rate is also affected by the level of natural income a portfolio produces.

For example, if a portfolio has a dividend yield of 1 per cent and your client requires 4 per cent per year, there is 3 per cent that must be met by capital erosion.

In a rising market this is generally not a problem as the portfolio value is increasing, however in times of falling markets we have a negative compounding effect.

This is sometimes referred to as ‘pound cost ravaging’.

On the other hand, a portfolio with a natural yield of 3 per cent only requires 1 per cent of capital erosion. This reduces the negative compounding effect significantly.

Does the safe withdrawal rate still work?

In his 2015 study, US adviser and blogger Michael Kitces showed that for investors taking 4 per cent withdrawal and adjusted for inflation, most of the time the 4 per cent rule works in that when the retiree has been drawing down on the pension for 30 years, there is still money in the pension pot.

In around two thirds of cases, the client finishes the 30 year retirement time horizon with more than double their starting capital.

In fact, the study shows that less than 10 per cent of the time the retiree finishes with less than the starting principal amount (this is assuming a 60/40 equity:bond portfolio).

Investing for Income versus Total Return

From the above analysis you may be tempted to look at portfolio options that carry an attractive level of natural (dividend) income.

This is a very valid choice for some clients however one must appreciate that investing for income does require some skill to avoid ‘dividend traps’ and unsustainable levels of income.

In times when growth focused investments look attractive, there may be some relative underperformance from an income orientated strategy.

However, the inverse is also true - when economic and profits growth is scarce, a portfolio of income generating assets can outperform the wider market as these investments tend to look attractive for their defensive qualities.

As with many decisions in investing, there is no obvious right or wrong answer to which strategy is best.