This is part four of a series [1] on how to maximise your ISAs and SIPPs to achieve Financial Independence (FI).
*DEEP VOICE*
Previously, on How To Split Your Pot Between ISAs and Your Pension For Fun and Profit:
- Part one [2] set out the FI problem of retiring early using UK tax shelters.
- Part two [3] explained why the tax advantages of personal pensions make them superior to ISAs later in life.
- Part three [4] laid down a basic plan for judging how much you need in ISAs compared to SIPPs.
*CAMERA PANS DOWN TO A HUNCHED FIGURE DOING MATHS*
*THE ACCUMULATOR LOOKS UP AND BEGINS SPEAKING*
Customising the plan to your own situation relies on knowing what sustainable withdrawal rate [5](SWR) to use.
Before we get into that, I’ll recap the plan so far:
- We’ll live on our personal pensions from our minimum pension age onwards.1 [6]
- Our ISAs and General Investment Accounts (GIAs) bridge the gap between giving up work and popping the corks on our pensions.
- We won’t bank on our ISAs and GIAs lasting longer than those gap years. That enables us to balance the need to grow our wealth as tax efficiently as possible against retiring early without taking unnecessary risks.
- We’re not rich enough to ignore the risk of low growth or an unfortunate sequence of returns [7], so we’ll need a strong dose of risky assets (hello equities!) to reach our goal2 [8] plus a buffer zone of lower risk assets (we meet again, bonds and cash).
To ensure our FI plan [9] is based on something other than gut instinct, bum-clenching, and the sweet smile of Lady Fortuna, we’ll base our calculations on the best research we can.
As well as having a (very) rough idea of how much annual income [10] we’ll need and how long [11] it should last, we need to know how much wealth we must build before we can celebrate our independence day.
Cue letting off firecrackers in the office, stripping to the waist to the sound of Ride Of The Valkyries, and telling the boss we love the smell of resignation in the morning!
But I digress…
We need a credible sustainable withdrawal rate
SWRs are designed to guard against the disaster of drawing too much, too fast, too soon from our investments, and so running out of money like a gaggle of teenagers running out of gas near an axe-murderers’ convention in a spooky wood.
- Your SWR number is a guide to how much annual income you can sustainably draw from your portfolio given certain sassy parameters (see below).
Knowing your desired income and SWR enables you to calculate how much wealth you must first build to later sustain that annual cashflow at that rate of withdrawal.
See the bonus appendix at the bottom of this post for the maths.
A credible SWR is a good planning tool because…
- …it deals with the fact that we’ll be living off a volatile portfolio of assets that can fork out an unpredictable range of outcomes: good, bad, and indifferent. This is the root of sequence of returns risk [7] – the danger that a bad run of market returns exhausts a deaccumulation portfolio in short order.
- …excellent SWR research is publicly available and relevant to DIY investors relying on their own resources to plan their future.
- …SWR strategies can cope with historically bad investment returns, but aren’t so cautious that we must postpone our financial independence for years trying to guarantee safety [12].
- …SWR strategies enable you to withdraw a consistent, inflation-adjusted income for the duration of your retirement (subject to all-important caveats that you need to understand).
I understand that some readers prefer an even more cautious approach, or have already accumulated sufficient assets or income streams not to need to worry about SWRs.
That’s all well and good. But not everybody – including me – has that luxury. Safety costs money.
I’ll give you the information you need to use SWRs appropriately while understanding the limitations of the strategy.
From that vantage point, you can then decide if an SWR strategy makes sense to you. Just rest assured I’m not a 4%-rule groupie, or a lifestyle blogger with a course to sell.
For SWR parameters, caveats, terms and conditions, please read:
- SWR pitfalls [5]
- Choosing a conservative SWR to suit [13] your circumstances
- SWR levers [14] you can pull
- An alternative lower risk retirement strategy [15]
Choosing your SWR
I’ll base our SWR numbers on the research of Professor Wade Pfau.
Pfau is widely respected in the field of retirement research. He’s attacked the withdrawal rate conundrum from multiple angles. Also, he has researched SWR rates for time periods lasting from ten to 40 years.
That’s important because many of us will need two SWR numbers: [16]
- The rate at which we can withdraw from our ISA, so that we don’t run out of money before we can access our personal pension.
- The rate at which can we withdraw from our portfolio – combined across all accounts – so we don’t run out of money for the rest of our lives.
Pfau uses historic market returns [17] and Monte Carlo sims [18] to scope the variety of market conditions we may face in the future.
Monte Carlo sims reshuffle returns data to generate many more scenarios than are available from the historic record. They’re alternative history generators, enabling us to stress test our plans against extreme circumstances that didn’t occur. Think Great Depression followed by Great Recession.
Pfau has also produced SWRs curtailed by the high valuation, low interest rate world we face right now.
The weakness of Pfau’s research is that it uses US historic returns that have been relatively benign in comparison to the global investment experience.
Because Monevator readers are mostly non-US investors with globally diversified portfolios, we need to cross-check US research against accessible global data to make sure we’re not unwittingly adopting an SWR that’s too sunny for grey old Blighty.
That’s where Timeline [19] comes in.
Timeline is withdrawal rate strategy software designed for financial planners. It’s excellent, and thanks to its free trial, we can dial up global market returns data in both historic and Monte Carlo flavours. I strongly recommend you try the free Timeline trial and use it to stress test your own plan.
SWRs for ten to 50-year periods
Okay, that’s a lot of preamble to get to the money shot but here it is. Below you’ll find the SWR numbers I’m using to model our ISA / SIPP FI plan.
Because there isn’t one SWR to rule them all – and because we’re trying to get a grip on an uncertain future – I’m going to show you a range of SWRs for each time period. You can then make an informed decision about how conservative you want to be.
There’s a full explanation below of the terms used in the table.
This table could do with some explaining:
Timespan – The maximum period in years that you need your investments to last. For example you need your ISA to bridge a 15-year gap until your minimum pension age, you could choose a 5% SWR by the light of the Low Interest SWR column. If that ISA must last 20 years then choose a 4% SWR from the Low Interest SWR column.
What if you’re an in-betweeny? What if you have a 17 year gap to plug? If you’re an optimist then you’ll round 17 years down to 15 and choose a 5% SWR. If you’re cautious, then round your time horizon up, and choose the 20-year 4% SWR.
Or you could compromise with a 4.5% SWR, knowing that SWR rates are a curve and that a 4.5% SWR is supported by the historical and Monte Carlo results for the 20-year period.
For lifetime spending, most of us are best off choosing a 40-year plus timespan [4].
For eight-year periods or less: save enough in cash to cover your spending needs plus an inflation top-up.3 [20] The potential upside of equities isn’t worth the risk of grievous loss with so little time to bounce back.
Historic SWR – Pfau’s research for 15- to 40-year timespans using US historic asset returns (1926-2014). (See table 1 [21] in his research paper).
Pfau provides SWRs for different asset allocations (0% – 100% US equities versus 100% – 0% US government bonds) plus success rates. Our table shows the best SWR for a particular time period and success rate. Click the table 1 link above to see Pfau’s asset allocation findings, and please also refer to our asset allocation section below. Pfau published an updated version of this research in his book How Much Can I Spend In Retirement? [22]4 [23]
Monte Carlo SWR – Pfau’s Monte Carlo simulation of ten to 40-year timespans using US asset returns data. See table 3 [24]. Success rates are converted into failure rates in that linked research paper. Again, click the table 3 link for asset allocation info and see below. An updated version of this research is also available in Pfau’s book How Much Can I Spend In Retirement?5 [25]
Low Interest SWR – Pfau’s Monte Carlo simulation of 15 to 40-year timespans using US asset returns data anchored to low interest rates. See table 2 [21].
Pfau’s sim is designed to reflect the low interest rate conditions that have hung over the world since the Great Recession. He allows assets to slowly rebound to their historic average returns over time.
Low interest rates reduce the expected returns [26] of equities and bonds, and so this column is especially relevant for anyone retiring in the next ten to 15 years. You can see that the Low Interest SWRs clock in around 1% lower than the historic and Monte Carlo norms.
Global Portfolio SWR – Timeline uses global asset returns data [27] that isn’t publicly available to produce withdrawal rate strategies suitable for UK investors.
I can’t just publish their data, but I’ve used their superb app to sense check Pfau’s work. The Global Portfolio SWR shown in the table is a downbeat take on Timeline results, using both historic and Monte Carlo scenarios.
The Global Portfolio SWR generally lags the US historic and Monte Carlo SWRs but it’s a sight better than the Low Interest SWR. Unfortunately, the Low Interest SWR is only based on US asset returns, albeit crocked by low interest rates, so a Global SWR equivalent could be worse still.
My Timeline results didn’t take into account current market valuations, although it looks like their Monte Carlo sim is flexible enough to do so.
Take heart though – the Global Portfolio SWR does incorporate the drag of 0.5% investment fees6 [28] while Pfau’s work skips that problem.
Success rate – This is the percentage of scenarios where the simulated portfolio didn’t run out of money before the end of the timespan. For example, a 6% Historic SWR left you with money in the bank in 99% of scenarios simulating a 15-year retirement. Note, the success rate may actually be 100% but I’ve adopted the Timeline convention of capping out at 99% because failure is always possible.
Any scenario that ends its run with so much as £1 left counts as a success. In reality, a retiree would almost certainly notice their balance plummeting long before and cut back on spending to prevent their portfolio going to zero.
Success rates for the Low Interest SWRs are much worse as you can see in the Success Rate Low Interest column.
Some research deals in failure rates, which are success rates for pessimists. A 95% success rate equals a 5% failure rate.
SWR patterns
The higher your SWR, the less wealth you need to have saved to deliver your desired income.
- SWRs are generally higher for shorter timespans.
- SWRs are lowered by higher success rates.
- Higher equity allocations are generally needed to maintain feasible SWRs over long timespans.
You can offset the negative effect of longer timespans by lowering your success rate and upping your equity allocation to some degree.
I’ve generally erred on the side of 99% success rates for ten to 25-year periods that I think of as the ISA years. You could lower the success rate if you don’t mind going back to work if you cop a nightmare scenario. You can also trim your success rate if you’re prepared to cut your spending by 10% to 20%.
The 30-year plus periods are personal pension territory and so I’ve reduced the success rates to 95% or 90% because you’ll likely have plenty of back-up options. These could include still having money left in your ISA, cutting spending if needed, equity release, using annuities, eventually drawing a State Pension, and/or failing to set a Guinness World Record for life expectancy [11].
I personally think success rates below 90% are unacceptable. There’s no getting around it in the Success Rate Low Interest column though – Pfau didn’t calculate the success rate for SWRs lower than 3%. You could cut your SWR to 2.5% or even 2%, or rely on the back-up options mentioned above should the worst case materialise in your lifetime.
If your retirement is many decades away then you can console yourself with the thought that historical norms may have reestablished themselves by the time you’re ready to use your SWR for real. I suspect many of us think a ‘new normal’ has descended upon the world, though.
It’s worth dwelling on Pfau’s cautionary note:
Historical withdrawal rates are not random; they tend to be lower when stock market valuations are high and when interest rates are low.
Both of these factors are at work today in a way that has been rarely experienced in the historical record.
If you’d like to know more about how SWRs are constructed and how sensitive they are to variations in volatility, inflation, asset returns, success rates, and the sequence of returns then check out Pfau’s deep dive [21] into the topic.
Meanwhile Timeline enables you to play with the parameters as if you’re sitting at your own financial mixing desk.
The upshot is there’s no point ceaselessly searching for the optimal SWR. It doesn’t exist. I’ve rounded the SWRs in the table to the nearest half point because precision creates a false impression of control.
Similarly there’s no point ceaselessly searching for cast-iron safety. It doesn’t exist. The point of this exercise is to provide a practical platform for planning.
Remember you also need to adjust your SWR to account for the cost of investing. We suggest you deduct 50% of your total expected annual fees from your SWR. (We only deduct half because of the mathematics [29] of a real-world portfolio drawdown).
I’ve assumed total fees of 0.5% (0.25% platform fees and 0.25% average portfolio OCF [30]), so I’d need to chip 0.25% off the SWRs from the table above (except the Global Portfolio SWRs which already include 0.5% in fees). For example, if I choose a Low Interest SWR of 5% then I need to pare it back to 4.75% to account for the impact of fees [29].
Make sure your retirement income is calculated gross of taxes and you’ll need to reduce your SWR again [13] if you want to leave a legacy. SWRs assume you can use up all your capital in the worst case scenarios.
SWR asset allocations for FI
Hunting for the optimal asset allocation to support your SWR is another fool’s errand. Table 3 [24] in Pfau’s research shows just how much asset allocations can vary and still come within a whisker of the same SWR result.
For example, an equity allocation of anywhere between 33% and 72% lies within 0.1% of the best SWR for a 40-year period with a 90% success rate. That’s good news if you don’t have a sky high risk tolerance [31].
Still, it’s worth understanding the ballpark asset allocations that supported the Global Portfolio SWRs for each timespan and success rate in our table above:
| Timespan (Years) | Global Portfolio SWR (%) | Global Equity/UK bonds/Cash asset allocation (%) |
| 10 | 8 | 30/30/40 |
| 15 | 5.5 | 30/30/40 |
| 20 | 4.5 | 30/30/40 |
| 25 | 3.5 | 60/40/0 |
| 30 | 3.5 | 70/30/0 |
| 40 | 3 | 70/30/0 |
| 45 | 3 | 70/30/0 |
| 50 | 3 | 70/30/0 |
Surprisingly few equities are required over periods of ten to 20 years to achieve a high success rate. That’s because the volatility of risky equities needs to be balanced by low risk assets over such a short time.
Pfau’s work with US returns shows much the same thing. Equities hover around 20% for portfolios that must survive ten to 20 years with a success rate of 99%.
Cash figures heavily because historical UK government bond returns are generally long bonds that got smashed during high inflation episodes, especially from 1947 to 1974. Pfau uncovers the same pattern in the US; allocations of around 40% cash (or bills) deliver success rates of 99% for ten to 20-year timespans. Cash [32] is an underrated [33] asset that dampens volatility and it does better against unexpected inflation than is commonly assumed.
I found the 70:30 portfolio results could all be improved upon in Timeline by going to an 80:20 equity:bond allocation. Yet beware of torturing the data and ending up with a concentrated portfolio that’s optimised for the past. History rhymes but it doesn’t repeat. Past results can impart useful guiding principles, but shouldn’t lead us to fight the last war by banking everything on a Maginot Line of, say, 100% small cap equities.
Pfau also says that historical data is biased against bonds because the overlapping retirement periods examined by historical sims overweight the middle part of the track record. That period coincides with a savage bear market for bonds.
Monte Carlo sims don’t suffer this problem and tend to show that higher bond allocations can support higher SWRs than assumed by historic data research. Again, see Pfau’s table 3 [24].
I wouldn’t blame anyone for cutting back their bond allocation [34] given the current outlook but you should still hold a substantial slug because diversification is your best defence [35] against an uncertain future.
Caution ahead
The green numbers in my table above are the SWRs I’ll employ in the upcoming and earth-shattering case studies later in the series.
I’ve picked the most conservative SWRs available from the range because they’re likely to protect us from bad outcomes [36] – short of The Four Horsemen defecating on humanity’s doorstep.
Indeed one of the problems with SWRs is that they often leave too much money on the table [37] if you don’t suffer a terrible sequence of returns. Don’t feel pressured to heavily discount the green SWRs in the table if it means you must spend so long building a bomb-proof level of wealth that you will never get to enjoy it.
Ultimately an SWR is our placeholder for an unknown future, and we could debate it until the future arrives.
Nobody should delude themselves that any system can bestow safety or a perfect outcome. Choose your trade-offs, understand your risks, enjoy your independence, adapt as you go. That is what this series is about.
The plan we’re sketching is not a forecast. It’s just enough to get us off on the right foot. Prepare to take further steps along the way.
Next episode: You’ve probably noticed that choosing a suitable pre-pension SWR relies on knowing how long your ISA / GIA should last. We walk through the full financial independence calculation [38] that enables you to work that out and finally get your ISA and pension working in tandem to achieve FI.
Take it steady,
The Accumulator
Bonus appendix: SWR maths is fun!
How much wealth do you need to sustain an inflation-adjusted income?
It works like this:
Divide your required FI income by your SWR.
For example:
£25,000 / 0.05 (5% SWR) = £500,000 stash required to sustain an inflation-adjusted £25,000 for 15 years – according to the Low Interest SWR column of our table above.
How much more would you have to save to increase your income by £1,000?
£1,000 / 0.05 = £20,000
£520,000 is therefore needed to support an inflation-adjusted income of £26,000 for 15 years with a 5% SWR.
How much less could you save if you earned £5,000 part-time a year for those 15 years?
£5,000 / 0.05 = £100,000 less required in stash.
Or, £20,000 / 0.05 = £400,000 stash.
How SWR withdrawals work
Year 1 income:
Multiply your portfolio’s value by your SWR
For example, if your SWR is 5% and your portfolio is worth £500,000:
£500,000 x 0.05 = £25,000 annual income
Year 2 income:
Adjust last year’s income by year 1’s inflation rate (e.g. 3%):
£25,000 x 1.03 = £25,750
The SWR percentage only applies to your first withdrawal. Every year after, you withdraw the same income as year one, adjusted for inflation, regardless of the percentage that this removes from your portfolio.
Year 3 income:
Adjust last year’s income by year two’s inflation rate (e.g. 2%):
£25,750 x 1.02 = £26,265
And so on. Every year ye shall live, or have money left.
Like this? Enjoy more maths-for-investors [39] fun with Monevator.
- The minimum pension age lies between 55 and 60, depending on when you’re born. [↩ [44]]
- The exception is bridging an eight-year or smaller time gap until accessing your personal pensions. It makes sense to rely on cash for periods as short as this. [↩ [45]]
- Or build an index-linked UK government bond ladder. [↩ [46]]
- Exhibit 4.5 page 87. [↩ [47]]
- Exhibit 4.8 page 94. [↩ [48]]
- And 0.5% should easily be enough to cover platform costs and a portfolio of keenly priced index trackers. [↩ [49]]