How to run out of life before you run out of money

Early in my career as a financial adviser I met a new client who was approaching retirement. I asked what he was trying to achieve with his money during his retirement. He responded: “I want to live the life of Riley and when I die, for the cheque to the undertaker to bounce.”

That statement has stayed with me because it was so simple in principle, but rather more difficult to apply in practice.

Having the freedom to retire is something many people dream of. But for many, having enough money to enjoy that freedom, which might last 30 or 40 years, is becoming a challenge.

A guaranteed private pension income is becoming as rare as a pregnant panda. Increasingly, and since “pension freedoms” relaxed the UK rules regarding annuity purchases in 2015, people need to fund the bulk of their retirement spending from invested capital.

In retirement, you face several unknowns. How long will you live? Will you suffer poor health? What other life events might happen? What investment returns will markets deliver? And what taxes will you suffer?

Know the true cost of living in retirement

You need to be clear on the cost of your desired lifestyle in retirement, split between core living, a contingency fund for unexpected expenses, spending on fun and luxuries and any gifts or financial support you want to give others in your lifetime.

Understanding what spending you’re prepared to reduce or stop in the event of a stock market meltdown or persistently low investment returns is your first line of defence against running out of money.

A sustainable withdrawal rate

If you draw down too much income from your portfolio each year, you’ll greatly increase the chances of running out of money. On the other hand, draw too little and you might not enjoy life as much — and may end up leaving a much bigger legacy than you envisaged. Failing to plan ahead raises the possibility that the tax authorities will be one of your significant heirs in the form of inheritance tax.

A rough rule of thumb from the US is that an investment portfolio allocated equally to shares and bonds could sustain, for 30 years, an annual withdrawal rate starting at 4 per cent of the initial portfolio value, increased each year by the amount of inflation.

More recent research by Morningstar suggests the comparable starting annual withdrawal rate for UK investors is nearer to 3 per cent (increasing by inflation) to account for lower historic capital market returns outside of the US.

An alternative approach is to take only a fixed percentage of the portfolio each year. This reduces the possibility of running out of money, but is likely to see annual withdrawals fluctuating significantly as the portfolio moves up and down in value.

A sensible investment strategy

How you invest your portfolio can also determine the sustainability of annual withdrawals. Invest too conservatively for the withdrawal strategy and you’ll run out of money. Invest too aggressively — particularly in the first 10 years of withdrawals if the portfolio suffers poor returns — and you’ll also increase the chance of running out of money. This is known as sequence of return risk.

Conventional wisdom suggests that as you approach retirement, you should move more of your portfolio out of equities and into bonds as a retired worker can’t replace any capital lost from a stock market crash or prolonged period of poor returns. However, more recent research from the US suggests that while gradually reducing equity exposure in the 10 years leading to retirement makes sense, the optimal withdrawal strategy is where the portfolio’s exposure to equities is gradually increased in the first 10 years after retirement. This approach is known as the V- or U- shaped equity glide path.

Researchers have found that the optimal approach is to reduce exposure to equities to between 20 to 40 per cent of the portfolio by the time of retirement, and then gradually increase exposure to equities over the first 10 years of retirement to somewhere between 60 to 80 per cent.

To find the right approach for your own circumstances, you might find it helpful to discuss some of these strategies with an independent adviser.

And while the undertaker might not take kindly to the cheque for your funeral bouncing, if you devise a sensible portfolio withdrawal strategy in retirement, the day of financial reckoning will be a long time coming.

Jason Butler is an expert on financial wellbeing and author of Money Moments: Simple steps to financial wellbeing Twitter: @jbthewealthman