He commented, ‘There are ways to enjoy certainty. You can buy an inflation-linked annuity, with provision to pay out to your spouse if appropriate; do this and you need never worry again.
However in order to do this, you’d have to accept a starting payout of around £2,600 a year for every £100,000 invested. If you wanted an income of say £15,000 a year, you’d need a pension pot of around £575,000.
Current monetary policy has compressed interest rates, including the yield on the Gilts and corporate bonds on which annuity providers rely to painfully low levels.
The jury is still out on whether interest rates are simply at a low point in a cycle, or have in fact become structurally low and this is a new normal.
Either way they are certainly persistently low and notwithstanding comments recently from our new Prime Minister about the negative impact of low interest rates on individuals’ savings, I see little sign today of a strong political desire to raise interest rates as such an act would most likely do more harm than good.’
McPhail continued, ‘If you aren’t interested in buying a guaranteed income, what do you do instead? Any alternative retirement income arrangement is going to involve leaving your hard earned savings in the investment markets, which means they can go down as well as up.
This is understandably unsettling for many investors, who have no desire to see the value of their retirement fund falling.
Under such circumstances, if you draw too much income from your fund, you could end up depleting the pot or even running out entirely and unless you are fortunate enough to die at just the same moment, this could be a problem.
There is a way to reduce this risk, a way to take an income from your fund which is likely to grow over time and which avoids eating into your capital. Your fund could (almost certainly will) fall in value at times but it should also rise and over time it should keep rising.’
He added, ‘The answer is to simply take what is known as the ‘natural yield’ from your investments. This means living off the income generated by your investments, the dividends from shares, the interest from cash and bonds, the rental income from property and so on: you don’t sell investments to pay an income.
The advantages of this approach are that you are far less likely to run out of cash and you are far more likely to enjoy a rising income.
When we back-tested the data, based on the FTSE All Share Index, we found that whilst there have been years in which this strategy would have seen your income drop from one year to the next, the overall trajectory of the income payouts was upwards and after 26 years the income was 3 times higher than it had been at the start, far outstripping inflation.’
McPhail continued, ‘The downsides to this strategy are that you do not entirely eliminate the risk of your capital expiring because if all the shares you invest in become worthless then your money is gone, however if you have invested in a diversified portfolio of UK and international shares and they have all crashed to zero, we’ll probably have bigger problems on our hands.
The other main drawback with this strategy is that you have to accept a starting income of only around 3.5 per cent of your capital. For some this won’t be enough but the reality is that if you increase this rate if income withdrawal, you also start to increase the risk of running out of money.’