Q. I am 67 years of age and have used an Allocated Pension to provide for our income needs in retirement. Under the law, I am obliged to draw at least 5% of my account balance out of my Allocated Pension on a yearly basis. Given the current investment climate for shares and the interest rates available on deposits, I am concerned that I will be forced to draw on capital. Should I be worried about running my Capital down and what is a safe draw rate to ensure we don’t run out of money?
A. The conventional wisdom in Financial Planning has always been that a safe draw rate from an Allocated Pension is 4-5%. Various academics have back tested this theory over the 20th century and the results have supported the notion that a draw rate of 4% a year could be supported for 30 + years in retirement in all market conditions experienced to date.
Volatility in markets during the global financial crisis and other 21st Century market downturns have challenged this conventional wisdom.
One of the major risks retirees face in providing adequacy of income in retirement and ensuring their money does not run out is “Sequencing” risk. Sequencing risk is the risk of experiencing poor investment performance at the wrong time. The “wrong time” is typically at the commencement of the Retirement income stream or when income is required to be drawn to provide income.
To minimise the impact of sequencing risk consider the following:
Diversify your portfolio across a range of investment classes; shares, property fixed interest and cash.
Diversify your assets by region and sector. Typically this would refer to shares but also is important in fixed interest and property markets.
Do not chase income yield or capital growth by having too great an exposure to growth or volatile asset classes. Always invest in accordance with your risk profile.
Do not discount using defensive assets due to the low yields offered. Consider exposure to defensive assets such as fixed interest and cash as a form of portfolio and income insurance.
If markets do fall, avoid crystallising losses on selling growth assets. Draw your income from defensive assets such as cash and fixed interest and allow growth assets time to recover if they are undervalued by the market.
Do not try to pick the top or bottom of the market. Regularly rebalance your portfolio, taking profits from growth assets when markets are up and rebalance from defensive assets into growth assets when markets have fallen.
Notwithstanding the steps you can take to minimise the future impact of sequencing risk, it is the actions that investors take as a consequence of these events that in the majority will determine the long term damage to income sustainability.
In terms of the sustainability of draw rates for Allocated Pensions, if you draw at or near your minimum obligation, provided you have taken the steps above and have an appropriately diversified portfolio, based on the evidence to date you should not be worried about running out of money.
A common sense approach needs to be applied, draw at the minimum during poor returning years and draw below the rate of return in years of strong market performance.