Why the “4% rule” could put your retirement finances at risk

When you’re accessing your pension, it’s important to consider the sustainability of your withdrawals. You might have heard of the “4% rule”, which provides a seemingly simple way to calculate how much you can access each year. However, for modern retirees, applying this rule to your pension could be risky.

The 4% rule was first articulated by William Bengen, a retired US financial adviser. The rule essentially suggests you can withdraw up to 4% of your pension each year without fear of outliving the money. In fact, Bengen said 4% was the worst-case scenario for retirees and suggested a withdrawal rate of 7% would often be “safe”.

The 4% rule sounds simple, so it can be tempting to put it into practice yourself. Yet, it could leave retirees short in their later years.

With many retirees fearing that they may outlive their pension – a report from This Is Money suggests almost half of retirees worry about this – read on to find out why you shouldn’t rely on the 4% rule.

4 compelling reasons to avoid the 4% rule

1. Longevity has increased how long your pension might need to last

One of the key challenges when deciding how much you can sustainably withdraw from your pension is that you don’t know how long it’ll need to last.

Bengen based his 4% rule on the need to create a retirement income for 30 years. Yet, there’s a real possibility that many modern retirees will need to fund a longer period than this.

Data from the Office for National Statistics suggests a man retiring today at age 60 would, on average, need to fund 25 years in retirement. Yet, there’s a 1 in 4 chance he’d live to be 92 and a 10% chance he’d celebrate his 97th birthday.

So, while a plan to spread your pension over 30 years might seem sensible at first glance, there’s a risk that you could run out of money in your later years.

For women, the risk could be even higher. A 60-year-old woman has an average life expectancy of 87, with a 1 in 4 chance of reaching 94 and a 10% chance of marking her 98th birthday.

As life expectancy continues to rise and retirees will likely need to draw on their pension for longer, using the 4% rule could become even riskier.

2. Periods of high inflation could mean withdrawing too much

When Bengen first named the 4% rule, he noted that retirees should adjust their annual withdrawals by the rate of inflation to maintain their spending power.

As recent events have shown, inflation isn’t always stable. A period of high inflation could mean you end up needing to withdraw higher sums to maintain your standard of living and deplete your pension faster than you expect as a result.

Inflation began to rise in the UK in 2021 and reached a peak of more than 11% in 2022. While the figure has fallen, it’s had a lasting impact on the budgets of households, including retirees.

According to the Bank of England, if you retired in 2021 with an annual income of £35,000, average inflation of 8.9% would mean your income would need to rise to more than £41,000 in 2023 to provide the same spending power.

That’s a huge jump in just two years. Over a retirement that might span decades, inflation might affect your income needs more than you anticipate, especially if events outside of your control lead to periods of high inflation.

3. Investment returns cannot be guaranteed

Another assumption that Bengen makes is that investment returns will help your pension continue to grow in retirement.

It’s important to note that investment returns cannot be guaranteed.

In addition, Bengen used historical performance figures from the US stock market, which isn’t a reliable indicator of future performance. While his calculations held up when compared to market performance between the 1920s and 1970s, that doesn’t mean it’s automatically the case for your portfolio.

It’s often important to consider how your pension is invested and whether it reflects your risk profile.

As well as understanding the potential returns, reviewing how the value of your pension could be affected during downturns could improve your financial resilience in retirement.

4. Your retirement income needs may not be static

Another drawback of the 4% rule is that it assumes your income needs will remain the same throughout retirement. In reality, many retirees find their outgoings change.

For instance, you might spend more in your first years of retirement as you make the most of having more freedom. Or you might plan to provide family members with financial gifts in the future, which may affect how you use your assets to create an income.

Another possibility retirees might want to consider is needing care or other type of support later in life. If you need to rely on care services, your outgoings could rise sharply in your later years.

A tailored financial plan could help you create your own pension rules

One of the biggest downsides to the 4% pension rule is that there’s simply no one-size-fits-all solution. How much you may withdraw from your pension depends on a whole host of other factors, from your retirement plans to what other assets you have.

So, instead of relying on a seemingly simple rule, working with a professional to create a tailored financial plan could help you devise your own set of rules to give you retirement confidence. Please contact us to arrange a meeting.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.

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