Rule of thumb takes the guesswork out of retirement

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YourLifeChoices recently wrote about a ‘rule of thumb’ that helps to explain how much retirees should draw down from their savings.

Retirees don’t want to spend too much, for fear of running out of money, but equally, they want to be able to live a comfortable life in retirement. How much is too little or too much?

The good news is that plenty of YourLifeChoices members read the story, and quite a few asked further questions. So, as one of the authors of the rule of thumb, I’m responding.

The main worry for retirees is, can I run out of money using the rule of thumb? And the answer is no. The rule of thumb always suggests spending as a percentage of the balance of an account-based pension (ABP) at the start of the financial year.

So, as long as you stick to the rule of thumb, it is not possible to completely run out of money. 

In addition, when an ABP balance runs low, assuming that the retiree meets eligibility requirements, he or she is entitled to the full Age Pension, thus accessing two sources of income.

How the rule of thumb works
To recap, the simple, three-part rule of thumb was devised by a team of five actuaries. We ran a complex range of calculations to help single retirees who have reached Age Pension eligibility age. We assumed that the retiree would own his or her home and receive a part or full Age Pension.

People want confidence in how much they can draw down. A lot of the modelling is very complicated, and the software is expensive. But the rule of thumb is simple, easy to remember and takes into consideration a retiree’s asset base and age.

The simplest rule of thumb guide is that a retiree should:

  • draw down a baseline amount, as a percentage of the balance of their account at the start of the financial year, that is the first digit of their age
  • add two per cent if their account balance is between $250,000 and $500,000
  • the above is subject to meeting statutory minimum requirements.

So, a 68-year-old single female with an ABP balance of $375,000 would draw eight per cent (or $30,000 per year) in addition to a part Age Pension.  To meet the statutory requirements around minimum drawdowns, once you are 85 or older, you need to draw at least nine per cent of the balance of your account at the start of the financial year (and higher percentages above age 90), regardless of your account balance.

That’s how the rule of thumb works for single retirees.

But many members asked, what happens if you are part of a couple, as most people are at retirement? Or, what happens if you are not a homeowner and rent in retirement?

How the rule works for couples and renters
My crack actuarial co-authors and I have attempted to answer some of these queries, by extending our rule of thumb. We take a look at the circumstances for a single, non-homeowner; a couple who own their home and a couple renting in retirement.

We have not performed any mathematical calculations to support the extended rules, but what we suggest is analogous to the rule of thumb proposed in our paper for single homeowners. 

To derive the new rules of thumb, the first key point we noted is that the special higher drawdown for single homeowners with assets between $250,000 and $500,000 is caused by the impact of the assets test. If you are a single homeowner and your assets are in this range, there is a strong incentive to spend them down so that you are entitled to receive more Age Pension. And, so, when we turn to single retirees, who don’t own their own homes, or to couples, the asset band where the extra two per cent drawdown applies, needs to move in line with the way the asset testing range moves in these different situations.

The second key adjustment we need to make when considering couples is to use the younger of the two partners’ ages as the basis for the drawdown rule. That makes sense intuitively, because usually it is the younger partner who will survive for longer – especially if the younger partner is female, which is often the case.

These insights lead us to the following ‘rules of thumb’ for the situations not explicitly addressed in our formal paper.

Single retirees, who do not own a home and are at least 65, should:

  • take the first digit of their age and draw down that annual percentage of the beginning-of-year balance of their ABP
  • add two per cent if their assets, subject to the assets test, fall in the range $500,000 to $750,000
  • always ensure that the amount to be drawn down from the ABP is at least the statutory minimum (especially from age 85 and above).

 A home-owning couple, aged at least 65, should:

  • take the first digit of the age of the younger member of the couple, using that to draw down an annual percentage of the beginning-of-year balance of their ABPs
  • add two per cent if their assets, subject to the assets test, fall in the range $450,000 to $850,000
  • ensure that the amount to be drawn down from each ABP is at least the statutory minimum.

A couple who don’t own their own home should:

  • take the first digit of the age of the younger member of the couple, and draw down that annual percentage of the beginning-of-year balance of their ABPs
  • add two per cent if their assets, subject to the assets test, fall in the range $700,000 to $1.1 million
  • always ensure that the amount to be drawn down from each ABP is at least the statutory minimum.

We think that the rules of thumb will be very useful to many people. But we also want to emphasise some of the key assumptions we worked from to develop the optimal drawdown rules.

What the rule of thumb assumed
If you are thinking about using our simple guide, here’s what you should know about our work.

We assumed that retirees are old enough to qualify for the Age Pension, are eligible for the Age Pension and subject only to the assets and income tests.

We also assumed that singles or couples are not earning an income from employment and that there is no specific bequest motive, other than perhaps an intention to leave the family home to beneficiaries. Having said that, as noted above, if you follow the rule of thumb, there will always be something left in your account-based pension when you pass away. It’s just not possible to know in advance how much will be left.

We also assumed that the assets in an ABP earned an investment return (net of expenses) at a rate equal to the rate of increase in average weekly earnings plus 3.5 per cent a year, and retirees held no assets outside superannuation other than possibly the family home.

Retirees also asked us if the real value of their spending would be maintained under the rule of thumb.

There is no guarantee that the real value of your drawdown will be maintained. If you follow the rules of thumb, whether the value of your drawdown is maintained in, say, your 70s, depends on whether your investment returns are equal to, or exceed, the rate of inflation plus your seven per cent drawdown rate.

In particular, if you survive to an advanced age, it is likely that the real value of your drawdowns will diminish over time.

Retirees also asked about the impact of holding more conservative investments and lower returns. The rule of thumb was based on an investment return equal to the rate of increase of average weekly earnings, plus 3.5 per cent.

This investment return target is reasonable for a ‘balanced’ fund with 70 per cent of its investments in growth assets. If you select a more conservative asset allocation, the optimal drawdown rates would be lower than those suggested by the rule of thumb.

Does the ‘rule of thumb’ work for you?

John De Ravin is a retired actuary whose career included work in the Australian government actuary’s office and in insurance. He has degrees in science and economics, an MBA and a graduate diploma in financial planning. He is a Fellow of the Actuaries Institute, a Fellow of Finsia and a CPA and author of Slow and Steady: 100 wealth building strategies for all ages.

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Disclaimer: All content in the Retirement Affordability Index™ is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.

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