Can we increase our pension withdrawals by 4% a year?

Fabian and his wife are ages 65 and 64. He stopped working full-time in 2007 and fully retired in 2010. He and his wife have two financially independent adult children and one grandchild. Their home is worth about £1.5m and mortgage-free.

“We want to maintain our current lifestyle and avoid relying on our children in old age,” says Fabian. “In about 10 years, we expect that we will move to a house that's easier to live in but not necessarily to raise funds. Although for inheritance tax (IHT) purposes it would make sense to maintain the value of my self-invested personal pension (Sipp) and draw funds from our home, we would prefer not to do equity release. So we expect that the main asset that we will pass on to our children will be our home.

“My wife receives £5,000 a year from a former workplace pension and has around £70,000 in a Sipp that she has not drawn from or contributed to for a number of years. We also receive about £1,500 a year from solar panels, and will both qualify for the state pension later this year.

"I transferred my final-salary pension into a Sipp in 2005 and qualified for full exemption from the lifetime allowance restrictions, as long as I don't make any more pension contributions. Our annual drawings from it have varied significantly, in part because we used it to help our children buy homes. Since then, we have typically withdrawn £100,000 from it one year and £200,000 the next.

“If our next withdrawal from my Sipp is worth about 3.75 per cent of its value, would it be possible to increase the value of future withdrawals by 4 per cent a year, sustainably? And if so, should we change the investment strategy of the pension? Also, as my Sipp has enhanced protection, is the asset allocation suitable or should we change it?  

"I have personally managed my Sipp since 2005 before which it was administered by a private bank. I have tried to maintain the Sipp's allocation to equities at around 60 to 70 per cent. And due to the poor prognosis for the UK market and sterling, I have maintained a relatively high proportion of this in overseas equities.

"I prefer passive funds, though invest in markets where liquidity is restricted or there are scale issues via active funds.

"The Sipp's overall returns have been volatile, especially after the financial crisis in 2007 and the outbreak of the coronavirus pandemic in 2020. But it has recovered reasonably well. I try not to change the holdings a lot, but when markets have looked particularly strong I've sold equity funds and allowed the cash allocation to rise to around 25 per cent of the Sipp."

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Chris Dillow, Investors' Chronicle's economist, says:

It is probably reasonable to increase the withdrawal rate from your Sipp, but you can’t be certain. Consider the expected returns from this portfolio. Equities might offer 5 per cent a year after inflation as this has been their long-term average. But cash, bonds and gold offer negative real returns of around -2 per cent. Nearly three-quarters of your Sipp is in equities and property, which implies it will make a real return of 3 per cent a year. So if you increase your withdrawal rate say to 4 per cent a year, you should budget on increasing the run-down of your portfolio from 0.75 to 1 per cent a year. 

But uncertainty about future returns is great – even over long periods. To roughly quantify this, let’s assume that your equity holdings have an annual standard deviation of 15 per cent. The emerging market holdings add to volatility, but sterling tends to fall at the same time as equities helping to mitigate the volatility of overseas equities. Such volatility implies that over 20 years the standard deviation of annualised equity returns is 3.3 percentage points. This means that there’s a two-thirds chance of them being somewhere between 1.7 per cent and 8.3 per cent a year. And this implies that your Sipp has a two-thirds chance of real returns between 1.1 per cent and 5.4 per cent a year.  

However, this understates the risk you face because it rests on the dubious assumption that the distribution of future returns will resemble the past. But we’ve no assurance of that – we face radical uncertainty. So increasing your withdrawal rate slightly is small beer compared to investment uncertainty.

I don't see why you need to change your portfolio to increase your withdrawal rate slightly. Adding equities would increase the chances of you being able to preserve your wealth while you withdraw cash and of a big fall in value. Also, there’s no obvious way to improve your equity allocation. You could consider more UK exposure as UK stocks seem cheap. But they have seemed cheap for years and only become even cheaper. You could consider one of the many investment trusts that invest in defensive stocks as these tend to outperform over the long run. Or you could add a private equity investment trust, as long-term growth might come from companies that are not quoted on public markets. But these are second-order considerations. 

Rather, the question is whether you have the resilience to cope with such uncertainty. I think you can because you plan to leave your home to your children rather than the Sipp. So why not run down your capital? It is only if you have an unusual mix of good luck with your health and bad luck with equity returns that you’ll come anywhere near to running out of money.

Having spent a lifetime saving and adding to wealth, running it down may feel weird – even if it is a logical thing to do. It’s hard to make logic triumph over our instincts, but we should try.

James Herbert, senior wealth planner, and Tom Planterose, senior portfolio manager, at Sanlam UK, say:

An increase of 4 per cent a year on your current £150,000 income is a bit optimistic. If you do this, by the time you are age 80 your income withdrawals will have grown to £270,141 a year. But your spending habits may reduce with age –something to monitor as unspent pension withdrawals will accumulate in your estate adding to its IHT liability.

I would break down your current expenditure, identifying points when you may be less eager to travel or not quite as active, perhaps at age 75 or 80. Then recalculate what your future expenditure needs might be. Also try to identify how your income requirement would change if one of you passes away to help decide choose the beneficiaries of your pension. Consider how much would be sustainable for the survivor and consider including your children as pension beneficiaries, as this can be very helpful when IHT planning.

You could draw from your wife’s Sipp to increase tax-efficiency. She should be able to take 25 per cent of it tax-free and offset additional withdrawals against the remainder of her annual personal allowance, which is currently £12,570, until she starts to receive her state pension. This would allow you to spread out your own larger pension withdrawals. Your wife could make further withdrawals at a 20 per cent income tax rate, reducing the amount of higher-rate tax you pay on your withdrawals.

If you increase the value of your pension withdrawals by 4 per cent a year, your pension could be fully eroded by the time you are in your early 90s. And if there is a market crash or sustained volatility this could happen even sooner.

Establishing your capacity and tolerance for risk is a priority. 

Your Sipp is highly dependent on capital growth. It's difficult to see where a natural yield will be generated, given the allocations to low-yielding government bonds and commodities. If there is a market crash you will have to draw heavily from equity capital that has fallen.

The Sipp has a large bias to passive investments in regions that don’t necessarily form a large part of global indices, resulting in a large amount of specific risk. India and Australia are particularly cyclical economies, and many of the companies listed on their markets require high levels of economic growth to perform well.

If you want an income of 3.75 per cent and to maintain the value of the Sipp's capital in real terms, with inflation of 2 per cent you would need an annual total return of 5.75 per cent. We would expect this level of return with an approximate 65:35 split between equities and bonds. 

Equity markets grinding higher while we wait for rising inflation. This means that active management should do better over the coming years, so we suggest moving away from passives. We suggest investing directly in assets to maintain conviction and minimise costs, as funds drive the overall cost up.

Your equity holdings are overdiversified, but the fixed income and alternatives lack breadth. Government bonds have low yields and are susceptible to rising inflation so good quality corporate bonds would be better. You could enhance returns by investing in higher-paying bonds, which reduce specific and duration risk, mitigating their higher credit risk.

The inflation-linked cashflows of infrastructure and property offer better value than equities and government bonds. Ways to get exposure to them include Mapletree Logistics (SIN:M44U), a Singapore-listed logistics business that should benefit from Asian economic growth. And companies like Orsted (DEN:ORSTED) and Acciona (SPA:ANA) offer exposure to the shift to renewable energy.