Many people associate the word “drawdown” with withdrawals from a pension fund after retirement. But a pension fund is really just a tax shelter for investments. The principles of drawdown can be applied to all your investments, wherever held.
Before coronavirus struck, many of us who are either retired or planning to retire soon may have had an idea of what a safe drawdown rate was. In the wake of the pandemic there are many questions around this, such as:
- Is my rate of drawdown still safe?
- Should I move into less risky investments?
- Can I afford to retire when I’d planned?
- What about the legacy I’d hoped to leave?
- Is my drawdown approach to retirement planning the best?
Is my rate of drawdown still safe?
That comes back to the title of this article: what’s a safe rate? Investopedia has a useful article that gives a good summary.
Safety for one person might be recklessness for another. It all depends on your tolerance for risk. It’s long-term risk that’s most important, which is the risk that you might eventually run out of money. It’s not necessarily the same as the short-term risk of your investments falling in value. To balance these two risks you need to have a good understanding of your own risk tolerance.
As well as tolerance for risk, a safe drawdown rate depends on what else you have to fall back on. If you have a guaranteed pension that covers all your necessary spending, then a higher drawdown rate to fund only discretionary spending is less risky. But if your drawdown has to cover some or all of your necessities, then you’ll need to take less risk.
Another factor would be whether or not you own your own home. If you do and you were to run out of money, you could release some of your home equity. So maybe you can risk drawing down more than if equity release were not available to you.
If your investments have just fallen in value, you’re starting from a lower base. You can’t automatically assume that they’ll bounce back to their previous levels in the short term. It’s more important to look at the fundamentals, and whether your investments have good long-term prospects. If you’re in drawdown then you’re in it for the long term. Your safe drawdown rate, whatever ‘safe’ means, is bound to be less.
One thing that should help make it easier to live on a reduced drawdown, at least in the short term, is that there’s less opportunity to spend. While practising social distancing, your discretionary spending may be at an all time low. Now is perhaps the ideal time to develop less expensive habits.
Should I move into less risky investments?
You may need to consider rebalancing your investments. It may be that your risky investments (e.g. stocks and shares) have fallen more than your cautious ones. If so then your weighting will already have shifted towards the cautious side.
In that case, perhaps counter-intuitively, you might consider slightly increasing your weight in more risky investments that have better prospects for high returns. This could reduce your long-term risk, and protect the safety of your drawdown. But there’s another way you may be able to achieve this. If you’ve kept a cash reserve (as hopefully you have), then as you spend it you’ll be gradually rebalancing your total assets towards higher risk.
On the other hand, selling more of your risky investments might take away important growth potential from your investments. This would limit still further your safe drawdown amount.
It takes financial courage to buy stocks and shares at a time like this. In the words of Warren Buffet: “Fear is something I never felt financially. Some people can handle it psychologically. If you can’t handle it psychologically, then you shouldn’t own stocks because you’re going to buy and sell them at the wrong time.” In practise it’s not black and white, but a spectrum. Somewhere along that spectrum is your risk tolerance.
Can I afford to retire when I’d planned?
If your planned retirement date is many years away, it’s unlikely you’ll need to change your plans just now. But if you’re approaching your planned retirement, you might want to weigh up your options. The more years you work, the more you can accumulate. With share prices low right now, you’re benefiting from pound cost averaging. If you retire later you should be able to safely drawdown more from a hopefully bigger retirement fund.
But the decision is not purely financial. Retirement is a lifestyle change. For some it’s a positive change, for others less so. If you’re strongly motivated to retire, you need to weigh up your desire to do so soon against the fact that you may have less to spend than you’d previously expected. The first step is to run the numbers through a retirement calculator. This will give you the information to help you make the right decision.
If you’re already retired, then the question isn’t whether you can afford to retire but whether you’re risking running out of money. Once again a good retirement calculator should help you find out and, if necessary, put you back on track.
What about the legacy I’d hoped to leave?
For some of us, our retirement planning is not just about our standard of living but about what we leave behind after we’re gone. Clearly if you drawdown the same amount from a fund after it’s just lost value, the chances are you’ll leave a smaller legacy. If you’re risking your legacy, this means you’re also risking running out of money. So being flexible about discretionary spending is important.
Deferring retirement may be an option for some. For the already retired, the choice is between accepting the likelihood of a smaller legacy or considerably reducing drawdown; and this means reducing spending.
Is my drawdown approach to retirement planning the best?
It’s not drawing down from a pension plan that depletes your retirement fund; it’s spending the money. So rather than focusing on drawdown, it’s far better to focus on spending. There might be good tax reasons for maintaining a higher level of drawdown than needed for your present spending. If you draw down more than you spend you can pump the excess into an ISA.
Spending is what makes the most difference between success or failure of a retirement plan. Once you have a spending plan, you can work the rest around it, including:
- How much to draw down from your pension plan(s).
- Whether you should take a pension tax free lump sum all at once or as a phased drawdown.
- Investment of your remaining retirement fund.
- Tax planning.
- Whether or not buying an annuity would help.
- Home equity release considerations.
We designed our Intelligent Retirement Planning Calculator around these principles. Drawdown is just one element of your strategy, to ensure you spend enough but not too much; and that you stand a good chance of leaving the kind of legacy that you want.