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Burndown for early retirement – when an 18% withdrawal rate may be too conservative

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A career in stages

A quick look at people you know on LinkedIn confirms that most will have had up to 6 different employers by the time they’re 60. I’ve had seven.

What this means for advisers is that most customers seeking ‘At Retirement’ advice have a mixed bag of retirement assets and often a State Pension, perhaps worth something over £9,000. In addition, many households will have one or more preserved Defined Benefit pensions. In the case of advised clients, it’s not unusual for the household’s total secure retirement income to comfortably exceed £20,000 pa. So, with no risk of running out of money in extreme old age, the question is: can we afford to retire early?

One pot at a time

A common way of addressing the early retirement opportunity is to take one or more Defined Contribution pension pot and ‘burn it down’ from age 60 or 62 until secure income kicks in at 65 or 66.

Of course, if a couple are retiring together, it’s worth making sure, if possible, that both partners utilise their personal allowances. This will produce a combined £25,000 annual income, tax free, while aiming to preserve their precious PCLS cash, potentially in an ISA.

Do the sums add up?

How much income is needed for early retirement takes careful assessment for every individual or couple, but established patterns of spending can be a useful guide. When retirement replacement income ratios were researched in the 2004 Pensions Commission Report (and subsequently by the DWP in 2013), the guidance was that top earners need income of 50% of their pre-retirement earnings, median earners 67% and low earners 80% to maintain an established lifestyle. Whatever the planned income, once confirmed, it can be compared to available pots to see if the pension capital and other savings can provide a bridge to secure income.

What risk level?

A key step in this process is to decide on a risk grade for your burn down pot. This is a classic retirement risk conundrum. You want certainty of outcome but opportunity for growth, either to extend the period of early retirement and defer taking State Pension, or to increase income or create headroom for choice. Investing a burndown pot in cash is always an option, but probably only for the more wealthy or strongly risk averse.

The science bit

Actuarial stochastics can make the decisions about risk easier to manage. Parmenion’s IMT (as well as answering questions about lifetime income) gives an ‘Income to Date’ analysis. You feed in the client’s age, burndown pot value, choose a solution and portfolio risk level, create a withdrawal income and then actuaries Hymans Robertson will calculate the probability of success over the planned term. It is easy to toggle the risk grade and to see what impact that has.

A worked example

Say a 61 year old man, living in BA14, in average health wants £30,000 a year for five years until his 66th birthday. He knows from the Money Advice Service that a 5 year fixed term annuity to cover this need would cost £150,570 but gives him no inflation protection. He prefers inflation protection in early retirement to help maintain his lifestyle.

Using IMT, and selecting PIM Strategic Guardian Risk Grade 6, you see that initial capital of £175,000 offers an 86% chance of achieving £30,000 income while keeping pace with inflation over 5 years.

All IMT forecasts and regular withdrawals are expressed in real terms, in line with CPI. No adviser charge. Parmenion platform and portfolio costs included.

What if you lower the risk grade to Risk Grade 4? Interestingly, the chances of success increase to 96%. This is the opposite impact to that seen when planning income for life, when ‘growthier’ – more equity-led investment – generally offers better outcomes over the long term.

Some retirement planning tools assume modelling ‘income for life’ can be handled by modelling ‘income to date’ over a fixed time period, to, say, 95 years of age. Cutting out the risk of extreme old age from your analysis is, we believe, potentially misleading.

With such a high level of certainty, could we allow a lower amount of capital to be allocated to this early retirement plan?

Assuming an 85% confidence level is sufficient, you can edit the plan capital value down until you hit a level that gives you the score you are aiming for. In this case, the conclusion is that £166,500 would be enough to achieve the goal with the required degree of 85% certainty at Risk Grade 4.

You can use the stochastic forecast options to see what shortfall you might face with a poor investment outcome. At the worst 10% outcome level, the available income in the final year of this plan is £27,590, around £2,500 below target – a relatively small shortfall and a relatively unlikely outcome.

Of course, a good run in the markets could produce a pleasing surplus.

There really will be cases where drawdown from a portfolio at an 18% withdrawal rate could prove to be much too conservative. If you’d like to discuss how our IMT can support your At Retirement advice, please get in touch.