How much can you safely withdraw in retirement?
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The federal government's confirmation of a $1.6-million cap on contributions into superannuation pension accounts could have widespread implications for your retirement revenue incomes, and where you draw those from.
While current policy shifts in Australia have specific relevance for retirees drawing down their super as a pension, it is an issue of global relevance. The widespread issues of balancing withdrawals with variables such as longevity risk, tax and fees are addressed in a white-paper prepared by a number of global Morningstar experts.
Morningstar Australasia's managing director of research strategy, Anthony Serhan, prepared the Australian component of the paper. He will discuss this in detail at the Morningstar Individual Investor Conference 2016, which will be held in Sydney on Friday 14 October.
Brought to you by the number 4
The "4 per cent rule" is something that underpins the report. Serhan explains the origin of this figure, which was identified by a financial planner in the United States back in 1994.
"It's where we really started with this. And you have to go back 22 years," he says.
In an article published in the Journal of Financial Planning in the US, William Bengen, a financial planner, posed the question on behalf of a number of his clients who were approaching retirement: How much were they actually able to draw down?
"That's where it started. But I think as with anything, and we love things that can be simple, don't we--4 per cent sounds good? What we miss out on is some of the detail about where that rule came from," says Serhan.
He highlights that the study was first conducted in the US; it looked at returns for a balanced portfolio of around 50 per cent stocks and 50 per cent bonds; and it was based on historic data.
"And there are two other really important points: one, the 4 per cent is only used once. You use that to determine what you can spend in the first year of retirement then that dollar amount is indexed to inflation," Serhan says.
"Secondly, when he was doing this he really was focusing on this idea of a safe withdrawal rate. So he was saying this 4 per cent number is really the minimum you can look at over a 30-year period, assuming markets perform at some of their worst levels. So he is really locking in on that certainty idea."
Applications for Aussie retirees
Serhan explains how, in assessing the implications for Australians, "the first thing was to address one of the practicalities of life: fees".
"Whether you are paying somebody to manage your portfolio, whether you are paying an accountant, whether you are paying somebody to administer the portfolio, there are costs," Serhan says.
"So what we did first of all was introduce a fee of 1 per cent per annum into our analysis. And secondly, we looked at the Australian returns as opposed to US returns.
"So if you do a similar thing: Assume a 30-year period, 50 per cent Australian shares/50 per cent Australian bond rates with the fee level, the 4 per cent number drops to around 2.5 per cent."
Taken a step further, it looks at projected returns in the context of current equity markets and interest rates, and also within more diversified portfolios that also include a mix of Australian and international assets.
"When you do that, if you still want to be 99 per cent certain that withdrawal rate number comes out at around 2.9 per cent and if you are prepared to lower your certainty to around 8 per cent, the number comes up to 3.9 per cent," Serhan says.
"So you still get that range there, so in an Australian context there are some definite things you've got to allow for."
Select your own success rate
"One of the things everybody maybe felt a little bit let down about during the financial crisis was this idea that we always talk about what average annual returns are going to be, but no one told investors it could get anywhere near as bad as it did," Serhan says.
"And probability of success is one way of starting to think about a range of returns. You think about it: We say over the next 20 years we expect equity markets to do say whatever it is, 6 per cent or x per cent per annum.
"If you are saying, 'Okay, I'm prepared to work with that,' what you are saying is you are a pretty optimistic person. Because the reality is with any expected return it will come true in 50 per cent or you will get that in 50 per cent of the circumstances."
According to Serhan, individuals can adjust the certainty level they want regarding expected levels of return. Some will be happy with a 50 per cent certainty level, others will want something closer to 99 per cent.
"Some will say, 'I want to be dead certain that whatever I'm putting into here is going to come out.'
"Well, the reality is somewhere in between. That's what this paper does--it shows you a range of successful probability and success levels," Serhan says.
Overall, he believes equity markets will continue to provide reasonable returns against cash over the next 20 or 30 years, "but in our numbers, those projected returns are probably two percentage points lower from what they have been historically".
Get used to lower returns
"So, get used to this idea that returns are going to be lower. You have some choices, you can spend less, you can save more or you can satisfy yourself with a lower level of probability," Serhan says.
"Our safe withdrawal rates are similar to what we've seen in the past, but they are lower and importantly, these withdrawal rates will be even lower if, as the data shows us, people keep living longer.
"That's good news, isn't it? We are going to live longer. Well, maybe you've got to take that into account when you are thinking about how much you are spending today," he says.
Serhan also emphasises another finding in the report that is particularly relevant for retirees living off an allocated pension.
"If you want more certainty about your money lasting for the full duration of your life, you may need to save money outside of the allocated pension, or more importantly, you may need to put aside some of your annual payments from your allocated pension to another investment that you can draw upon," he says.
"The reality is we are all different and we need to look at this stuff one by one, and reviewing and this taking into account your own requirements, your own preferences, is still going to be the best way of working your way through retirement."
To ensure you don't miss out on an opportunity to hear more from Anthony Serhan about safe withdrawal rates, register now for the Morningstar Individual Investor Conference 2016.
Glenn Freeman is Morningstar's senior editor.
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