The 4% rule of thumb often used to define a sustainable approach for drawdown in retirement is no longer fit for purpose due to prevailing and sustained market conditions, according to Lane Clark & Peacock (LCP).
The “nastiest, hardest problem in finance” has become even tougher in a world of zero – or negative – real interest rates and quantitative easing (QE), the consultancy said, while the two-decade-old 4% rule “comes from a different world” and needs rethinking.
The withdrawal rate is causing many to run out of money while cautionary approaches to asset allocation, weighted towards bonds, “could be working against them” and lead to “years of lost income”.
Overall, the 4% rule is now three times more likely to lead to failure than a decade ago, due to both market conditions and increased longevity, creating “silent victims… left with much less sustainable retirement pots”.
In When QE Broke the 4% Rule, LCP estimated that a drawdown portfolio with a high allocation to gilts coupled with private wealth or financial advice fees could see an annual loss of 4% relative to inflation – with 60% of a portfolio’s real value eroded over a typical 23-year retirement and fees most to blame.
And while other spending rules can be used, these are often harder to implement and “easier said than done”, LCP added.
The consultancy simulated the impact on retirement prospects for various drawdown rates, investment portfolios, and advice expenses.
When looking at just portfolio construction and drawdown rate, it found that a 75%-plus return-seeking asset portfolio gave the best probability of good outcomes, while a 5% inflation-linked spending rule gave a one in four chance of running out of money.
A 75%-plus return-seeking portfolio could result in between 5.3 and 8.6 years of lost income in poor market conditions (or 7.4 years at a 5% drawdown rate), but there was not a great deal of extra downside risk if moving to an 85% return-seeking strategy, at between 6.1 and 8.8 years.
Nevertheless, withdrawal rates above 6% were equally likely to lead to many years of lost income no matter the risk in the portfolio strategies, LCP estimated.
Partner Dan Mikulskis commented: “Too much discussion around managing a pension pot in retirement is based on a world which no longer exists. With negative real interest rates and longer retirements, paying high charges to invest cautiously can greatly increase the risk of running out of money.
“Those who are set to be retired for 25 to 30 years should still consider investing a significant part of their retirement pot for growth. Old rules about ‘sustainable’ withdrawal rates are now dangerously unsustainable and need to be revisited.”
The consultancy urged the industry to improve cost comparability between providers by ensuring value for money throughout the investment supply chain and being transparent on costs, while also improving innovation, particularly around limiting longevity risk later in retirement.
It also called on the government to develop the “fuller working lives” agenda further to incentivise the healthiest retirement-age workers to continue working, while regulators should tighten their focus on value for money in drawdown.