Pensions industry urged to update assumptions as '4% rule' becomes 'unsustainable'

Pension schemes have been urged to revisit historical rules and assumptions, after analysis from Lane Clark and Peacock (LCP) revealed that the '4 per cent rule' is no longer likely to be sustainable for many people.

The firm revealed that the typical assumption that, for most people, drawing at a rate of 4 per cent of the original pension pot, increasing each year in line with inflation, is no longer likely to be sustainable due to “ultra-low interest rates", reinforced by Quantitative Easing.

Furthermore, the analysis stipulated that sticking to the ‘4 per cent rule’ is three times more likely to lead to a failure, such as running out of money, than in the market conditions recorded a decade ago, taking account of increased longevity.

Whilst LCP acknowledged that the 4 per cent rule has been “extensively analysed”, it emphasised that sharp changes in the market conditions mean that work done even four or five years ago needs to be updated, with investment and adviser charges often not fully factored in.

Indeed, the firms analysis argued that a combination of high charges and low-risk investment have created the “worst of all worlds”.

This in turn has seen current headline rates of return on low-risk investments so low that a combination of inflation and fees “eat away rapidly at the pot”, leading to a high risk of running out of money prematurely.

LCP has previously called for the abolishment of member borne flat fees on DC pensions, arguing that these can erode small pots away over time.

The firm has argued that adviser fees and other costs and charges are in many cases more important than asset allocation as determinants of sustainable withdrawal rates, with some examples from the report finding that the adviser earns more than investments do over the course of a retirement.

It also stated that there is a “strong case” for considering higher-risk investing in retirement, supported by good value advice, despite the greater risk.

According to the report, modelling showed that this approach can support a higher withdrawal rate in most scenarios than a conservative approach, particularly where there are advice fees as well.

The firm recommended that the ‘4 per cent rule’ is modified to reflect current market conditions, including moving to a lower steady rate of withdrawal, noting that the calculations that led to the 4 per cent rule previously would now imply a steady withdrawal based on 3 per cent of the original pot plus inflation.

Alternatively, it suggested keeping the cash level of withdrawal constant, rather than increasing for inflation, explaining that whilst this implies a modest real terms decline in annual withdrawals on this part of total income, it allows savers to gradually adjust their spending patterns and to reduce their chance of running out of money.

Commenting on the report, LCP partner, Dan Mikulskis, stated: “Too much discussion around managing a pension pot in retirement is based on a world which no longer exists.

“With negative real interest rates and longer retirements, paying high charges to invest cautiously can greatly increase the risk of running out of money.

“Those who are set to be retired for 25-30 years should, still consider investing a significant part of their retirement pot for growth.

“Old rules about ‘sustainable’ withdrawal rates are now dangerously unsustainable and need to be revisited”.

The firm has recommended that wealth managers and the financial services industry review whether fee levels have adjusted sufficiently to reflect the new environment of low interest rates and low inflation, and consider whether investment portfolios are taking sufficient risk.

It also urged the industry to come up with “low-cost and innovative products” to help savers to manager their money in drawdown in an “era of low returns”.

Meanwhile, the government and regulators were called upon to support and incentivise those who are willing and able to work beyond traditional retirement ages in order to enable them to build up a larger pension put which is drawn down for a shorter period.

Furthermore, LCP recommended that the regulator and government “bear down” on costs and charges in retirement, noting that these have “such a powerful influence” on investor returns.

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