Are pension withdrawal rates safe?

While Australia’s minimum drawdowns were decided on advice from the Australian Government Actuary, they hark back to a rule of thumb known as Bengen’s 4% Rule.

In 1994, after testing historic market returns, US financial planner William Bengen settled on 4% as the initial withdrawal rate that would preserve the average retiree’s nest egg for 30 years with a high degree of safety.

But the investment landscape Bengen was surveying has changed dramatically since 1994.

An era of low interest rates

Since the mid-1990s, ten-year government bond yields have fallen from as high as 7% in the US and 9.2% in Australia, to below 1% today.

Many retirees increase their exposure to defensive assets such as cash and bonds to preserve their capital. But with yields below 1% across the board, from savings accounts to long-term bonds, conservative investors are effectively going backwards after allowing for inflation. Hence the rethink about ‘safe’ pension withdrawal rates.

In today’s low interest rate environment, even Australia’s lowest minimum withdrawal rate of 4% (2% under temporary measures) would drain your savings faster than you can grow them.

The hunt for yield

For a while, shares did the heavy lifting for investors seeking better yields than those available from traditional income investments. Many retirees have come to rely on dividends and franking credits to boost their income.

But returns from shares have also taken a battering from the economic impact of the coronavirus. Some companies, notably the big banks which are a mainstay of retiree portfolios, are beginning to cut or defer dividends to preserve capital.

This serves as a reminder that while the interest rate on government bonds is pre-determined, dividends are at the discretion of the companies issuing them.

While the average dividend yield of the Australian market is still close to the historic average of around 4%, lower yields in future can’t be ruled out.

Reviewing the safe withdrawal rate

In a 2015 paper titled How Safe are Safe Withdrawal Rates in Retirement? An Australian Perspective, Griffith University academics Michael Drew and Adam Walk tested Bengen’s 4% Rule using Australian historic market returns.

Given that today’s retirees are living longer and life expectancy is likely to increase further, they looked at withdrawal rates that would provide various levels of safety over 30 years of retirement for different asset allocations.

For example, as you can see in the table below, someone with a 50:50 mix of shares and bonds and a 30-year retirement investment horizon, could withdraw just under 3% of their initial portfolio and be 100% confident that their money wouldn’t run out. If they were prepared to accept a 10% chance of falling short (90% safety), a withdrawal rate of 3.62% was considered safe.

Asset allocation (rebalance annually, 30 years)	Withdrawal rate as a percentage of initial portfolio value
	100% safety	95% safety	90% safety	50% safety
100% shares	2.74	4.20	5.13	7.63
75% shares/25% bonds	2.94	4.01	4.31	6.71
50% shares/50% bonds	2.96	3.54	3.62	5.37
25% shares/25% bonds	2.45	2.69	2.85	4.11
5% shares/95% bonds	1.66	1.83	2.04	5.37

However, in Australia most retirees with a super pension are invested in their fund’s Balanced option with 60–76% growth investments. According to the calculations in the table above, a 4% withdrawal rate would have a 95% chance of lasting 30 years. In other words, even though it seems counter-intuitive, ‘safety’ is increased by holding a meaningful amount in shares.

Note: For simplicity, the researchers assumed pension drawdowns are made each year on the initial portfolio value at the outset of retirement, which is the US practice. However, it should be noted that Australian super pension drawdowns are calculated on the account balance at 30 June each year. Drawdown rates are then increased as the retiree ages, rather than holding annual drawdowns at a constant 4% as in the US.

What withdrawal rates are safe for Australian retirees?

Index fund specialist Vanguard recently adapted US research for Australian conditions and came up with a range of 3.5% to 5% as a safe withdrawal rate, depending on how conservative your portfolio is. They also recommend retirees take a flexible cap-and-floor approach to spending.

In a recent article, Vanguard Australia head of corporate affairs Robin Bowerman wrote: “Those people willing to be flexible in year-to-year spending – pulling back in negative return years and spending more in good ones – dramatically increase their chances of not running out of money.

“In fact, a retiree who is willing to cut back spending in bad years by just 2.5% can lift their starting safe withdrawal rate as high as 5% of their savings – without increasing the chances of running out of money. The Vanguard numbers show the best result comes from capping spending increases each year at 5% ­– even if your portfolio grows faster than that.”

An argument for higher withdrawal rates

The Actuaries Institute of Australia also crunched the numbers recently, concerned that Australian retirees tend to stick to the minimum drawdown rates due to a fear their money will run out when many could afford to spend more.

A working group of actuaries assumed a portfolio with 70% growth assets and an average annual real (after inflation) return of 3.5%, which is close to the returns benchmark used by most public offer super funds. The result was a new rule of thumb they called Spend Your Age.

By ‘spending their age’, it was found that retirees could safely withdraw an amount beginning with the first number of their age and have confidence that their money would last around 30 years. That is, someone in their 60s could safely withdraw 6% of their super each year, while someone in their 70s could withdraw 7%. The rule breaks down for retirees aged 85+ when the statutory minimum rates are higher.

Even so, John De Ravin, a member of the working group, says a retiree with a more defensive portfolio and lower long-term returns might find a 4% withdrawal rate is closer to the mark if they want their money to last 30 years.

However, he says people who retire at certain points in history could be in trouble if they stuck to the 4% rule due to sequencing risk. That is, a big market fall around the time you retire can reduce the total amount of money you have to live on over the length of your retirement.

But what if the market tanks?

According to SuperRatings, Balanced pension funds (60–76% growth assets) returned 7.2% a year on average in the ten years to March 2020. Even Conservative investment options (20–40% growth) returned 5.6% on average.

So for the past decade at least, retirees have easily covered their minimum pension drawdown requirements without eating into their capital. But that’s looking back over an unusual period when bonds and shares were booming at the same time.

It is yet to be seen how sharp or prolonged the coronavirus market crash will be. However, Australian super funds are well diversified, with long-term investments in infrastructure and real property, as well as defensive investments in bonds and fixed interest, to offset more volatile assets such as shares.

The bottom line

If history is any guide, an initial 4% safe rate may be simplistic, but it is not too far wide of the mark.

The government’s temporary halving of minimum drawdown rates has given retirees more flexibility to manage their pension income during a time of market volatility.

Individuals may also choose to vary their annual drawdown (while paying heed to the statutory minimum for their age) depending on the performance of their super fund. People who retire early, and women (who tend to live longer than men), may need to take a slightly more cautious approach in the early years of retirement to have greater confidence that their money will last the distance.

“I don’t think we need to make the situation more complex by making the statutory minimum withdrawal rates more flexible than they already are,” says De Ravin.