Safe Withdrawal Rate Explained

Financial advisers have a crucial role in developing a sustainable withdrawal strategy (i.e., a ‘safe withdrawal rate’ ) for retired clients that ensures their pension fund lasts for their lifetime while accounting for inflation. This article is particularly relevant to the CII R04, J05, AF7, and AF8 units.

This article is correct as at 22 April 2023.

Safe Withdrawal Rate (SWR)

While the FCA does not provide a specific recommendation on an SWR, it does emphasise the importance of developing a sensible and sustainable withdrawal strategy for clients in retirement.

In the UK, a study based on market data over 100 years, assuming a portfolio with 60% in equities, put the SWR for the UK at 3.7%. For a portfolio with 50% in equities, the figure is 3.4%. 

Fine-Tuning the SWR

However, the actual SWR needs to be adapted for each client’s individual circumstances, as the original study assumes a period of 30 years in retirement. The SWR is also sensitive to asset allocation, which is affected by each client’s attitude to risk.

Advisers can improve the likelihood of the fund’s not being depleted during retirement by adjusting withdrawals based on market and portfolio conditions, such as taking income from asset classes that have experienced the most growth and adjusting withdrawals following poor market returns.

Sequencing Risk

Sequencing risk refers to the potential danger that occurs when the order or sequence of investment returns is unfavourable for the client’s drawdown pension fund. This risk arises when there is a significant decline in the value of a pension fund during the early years of the client’s retirement which can significantly reduce the client’s future expected returns. In other words, it is the risk of a market downturn during the early years of retirement, which can lead to a significant decrease in the value of the client’s pension fund, leaving them with fewer resources to support their retirement lifestyle.

Managing Sequencing Risk

Sequencing risk can be managed by having a diversified investment portfolio, including assets with a low correlation to the stock market and using a withdrawal strategy that takes account of market conditions. This can help to mitigate the impact of market fluctuations on the overall value of the pension pot, reducing the risk of running out of money in retirement.

In Conclusion

While the SWR provides a useful rule of thumb, its usage is declining. The latest research suggests that more financial advisers are using cash flow tools to evaluate sustainability for each client’s individual situation. Cash flow tools can give clients a clearer understanding of what income they can expect in a range of different scenarios. They also tend to suggest a lower rate of withdrawal than the SWR, which brings into question the validity of the SWR itself.

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Alternatively, you can download the taster for AF7 or J05 if you are preparing for one of those exams.