Investors will always run the risk of exhausting their fund if withdrawals are not made in a sustainable manner. One theory of preventing this is to employ a safe withdrawal rate (SWR).
An SWR is defined as the quantity of money, expressed as a percentage of the initial investment, which can be withdrawn each year for a given quantity of time, including adjustments for inflation, and will not lead to portfolio failure (where failure is defined as a 95% probability of depletion to zero at any time within the specified period).
The use of an SWR is a popular concept in the USA and Australia. The most popular ‘golden rule’ for an SWR is 4%. This was developed about 20 years ago by US-based financial planner Bill Bengen, who simulated timelines for simple stock and bond portfolios over several 30-year periods, starting from 1929. Using this technique, Bengen concluded that 4% is the highest percentage of the initial portfolio, indexed with inflation, that can be withdrawn without running out of money over a 30-year period.
However, the issue of what is a SWR remains one of the most hotly contested ideas in retirement planning. The current debate challenges the decades-held view that there is a simple, robust solution to the asset–liability mismatch faced by many retirees.
The advantages are that, if the member adheres to the safe level of withdrawals, they lower their risk of running out of the drawdown fund before death, rather than taking high withdrawals and increasing the risk of depleting the fund. The default level can be set when the member takes out the plan, and ideally is based on their life expectancy and used in conjunction with cash flow modelling.
Critics of the SWR believe that it is a blunt instrument, and argue that the withdrawal rate should be set based on individual circumstances and should change accordingly. Using a SWR does not mean the fund is immune from the vagaries of the stock market.
Someone who invested £100,000 in April 2015 and set a SWR of 4% from a typical balanced portfolio – 60% held in equities, 20% in corporate bonds and 20% in cash – would have seen a fall by around 14% to £86,813 in February 2016.
Another potential downside is that someone withdraws less than they can afford, and only withdraws 4% when they could afford to take a higher fund without depleting the fund before death. A 4% withdrawal rate may make sense at younger ages, but someone in their 80s could conceivably afford to take out more