Pension income drawdown: is the 4% rule dead?

Knowing how much to withdraw from your pension pot is all part of the retirement planning process. Alice Guy looks at the 4% rule and whether it still holds true for your pension income drawdown.

Wouldn’t it be great to have a cast-iron rule that tells you exactly how much you can afford to withdraw in retirement? The 4% rule is an attempt to do just that: it’s a long-established rough estimate of how much you can safely afford to withdraw from your pension pot during retirement. The aim is for your investment fund to last as long as you need it, with investment growth compensating for your withdrawals.

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The problem is that, like so many things in life, planning your retirement isn’t simple. And a one-size-fits all approach doesn’t always cut it.

What is the 4% rule?

In theory, you can afford to withdraw 4% per year from your pension pot, for example, withdrawing £8,000 per year from a £200,000 pension pot. If your pension pot averages 6% growth, there is 2% inflation and you withdraw 4% per year, your pot would remain the same in real terms and last indefinitely.

The rule is based on a 1994 study by financial planner William Bengen. But 1994 seems like a financial lifetime away: a time before the dotcom boom and resulting crash, before the banking crisis and long-term economic stagnation.

So, is the 4% rule still valid in a low-growth and potentially recessionary environment? Let’s take a closer look.

Four problems with the 4% rule

There are a few obvious problems with the 4% rule, which critics think is over-simplistic.

1) Based on past returns

The first problem is that the 4% rule is based on past returns and none one has a crystal ballto see the future. Bengen studied historical stocks and bonds over the 50-year period from 1926 to 1976, focusing on the stock market slumps of the 1930s and early 1970s. He worked out that, even during the bad times, a 4% annual withdrawal would never exhaust a retirement portfolio in under 33 years.

But looking forward, it’s difficult to predict next year, let alone 35 or 40 years’ time. If your pension wealth dips in value, withdrawing 4% can quickly erode your wealth and a stock market downturn could have a long-term impact on your wealth and income.

The 4% rule presents a potential headache if you retire in a period of stock market stagnation or a slump. For example, someone retiring just before the dotcom crash in 2000, with a pot of £300,000 and withdrawing 4% per year would now have around £315,000, a loss in real terms after inflation.

In contrast, someone retiring a few years later in 2003 would now have a pot worth £577,000. The huge difference is all due to the early losses of the 2000 retiree, as their pot dipped in value to £164,000 by 2002 and never fully recovered.

2) No investment fees

Bengen’s study also takes no account of investment fees, which can be significant for some investors, with many workplace schemes charging at least 1% per year. If you pay high annual fees, you might need to achieve stock market growth of 7% to cover your 4% withdrawals and still beat inflation.

To head off this problem, you could switch to a flat-fee investment platform to save significantly on your fees and protect your investment wealth. And switching to low-cost index funds, rather than expensive actively managed funds could also boost your investment wealth over time.

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3) Aggressive portfolio assumptions

Bengen’s model assumes that retirees invest at least 50% in equities, but this approach may be too aggressive for many cautious retirees whose main priority is to preserve wealth.

If you’re a cautious investor and invest less than 50% in equities, then you will need to take that into account when you’re planning for retirement and consider withdrawing less than 4%.

4) Individual circumstances affect your needs

All of us are different, and our own individual circumstances affect how much pension we might need to withdraw: the 4% rule might not always be appropriate.

For example, if you or your spouse have other sources of wealth, such as a defined benefit pension or a rental property, then you might not need to take as much from your pension pot. On the other hand, you might have a period with big expenses, such as medical bills or household repairs, and need to withdraw more than 4%.

And the wider economy also affects our income needs. During the Covid pandemic, many pensioners spent less, with holidays and leisure activities put on ice. In contrast, the current cost-of-living crisis will mean many are forced to spend more than planned to fund extra energy costs.

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Should you use the 4% rule?

So, do these problems mean we should shelve the 4% rule? Not necessarily. The rule can be a useful tool to help us prepare for retirement, especially if we adapt it for our own circumstances.

How you use and adapt the rule will depend on any other sources of income, your health and financial needs, your asset allocation and your financial needs.

Keep your portfolio under review

If you do decide to use the 4% rule to help plan for retirement, it’s important to keep your portfolio and income needs and investment growth under review. If you realise you’re withdrawing too much, then it might be time to review your spending or see if you can change your investment strategy.

Rebecca O’Connor, head of pensions and savings at interactive investor, says that, “if you are in retirement, then you will need to withdraw some cash from your pot for income. It’s important at this time not to take more than you need. Certainly, think carefully about what to do with a 25% tax-free lump sum. It might be best to delay taking it out if you can, and if you take it, be very careful about what you spend it on.

“In general, delaying taking money out or making any big decisions that lock in the value of your pot now rather than giving it time to rise again in future is sensible. If you are due to retire soon, this strategy might mean working for longer, if you can. If you have already made the decision to quit and retire, perhaps there are other forms of work you could do to keep a bit of money coming in but still allowing you to leave your formal work.”

And, when you’re planning for retirement it’s a good idea to speak to an independent financial adviser to work out the best investment strategies for your needs and how much you can afford to withdraw.

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Dividend income as an alternative to the 4% rule

So, what are the alternatives to the 4% rule? One possible option is to use dividend income in retirement: withdrawing dividends from your investment pot and keeping the capital invested

It’s a strategy that’s increasingly popular with investors: the Vanguard FTSE UK Equity Income Index fund was number six on the most-popular-funds list for ii in June 2022. The fund currently has an impressive dividend yield of 5.1%. Or if you’re looking for a global option, the Vanguard FTSE All-World (LSE:VWRL) high dividend yield fund has a dividend yield of 4.1%.

The good news is that generous dividends payers are also often so-called value companies: long-established firms with relatively stable profits and dividends. The share price is likely to suffer less in an economic recession than newer, growth companies.

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