Drawdown Pension Simulator.
The purpose of this simulator is to simulate the potential effects of using a Drawdown Pension plan to provide retirement income, depending on numerous factors, such as the initial fund value, the level of regular withdrawals, investment growth rate and investment volatility.
One major problem when looking at Drawdown Pension is that any initial projection works out the final projected fund value by using a linear averaged growth rate (minus withdrawals and regular charges). Usually this assumes that the initial fund value grows by 5%, 7% or 9% minus withdrawals and charges.
However, we know that in the real world investments do not grow at such a uniform rate. In some years they may increase in value by twenty percent, and in other years may lose as much value. Often there can be years of sustained losses and negative growth.
Using a standardised calculation, assuming that on average equity investments have averaged 8% growth over the last fifty years, you could draw out 8% in withdrawals every year and retain your original capital. This could work, but the chances are that you could end up with a seriously depleted pension fund in ten or fifteen year’s time.
For example, an individual who entered pension fund withdrawal in 1999 and invested in a significant amount of equity-based funds will have seen years of negative investment returns, primarily between the years 2000-3 and since mid-2007. Although the other years in this period registered impressive investment returns, if withdrawals continued to be taken during the bad years, this could have had a significant negative impact on the total pension fund, and it becomes much harder to get back to the starting point during the good years.
The key point here is that Drawdown Pension is more risky than annuity purchase (although there are pros and cons to both options), and there is no guarantee that it will succeed (unlike annuity payments that are as good as guaranteed, as long as you manage to stay alive). The main factors for success or failure are:
- Investment Decisions
The effects of timing cannot be ignored. If you get off to a good start, Drawdown Pension is more than likely to work in your favor. For instance if you had invested in 2003 and invested mainly in equities, your fund value, despite taking withdrawals, is likely to be worth more now than at the start date. Conversely, someone who commenced in early 2007 would have suffered years of negative or weak investment performance.
Investment decisions do matter. Some people may invest aggressively, and switch between equities, property and other exotic assets when they feel the timing is right. Such a strategy may work incredibly well, or fail very badly. This often depends on the investment skills of the person making the decisions.
Because most people are unhappy to take such big risks with their pension pots, most people “spread” their investments between different sectors and asset classes, and this is where the element of volatility comes into the equation.
Technically, volatility refers to the standard deviation of the change in value of an investment within a specified period of time (often 36 months). This quantifies the risk of the investment over that period. An easier way to explain this is that sometimes prices go up, sometimes they go down, and sometimes they barely move for long periods. For instance, if an investment fund had an average return of 5% and a volatility level of 20%, this means that the range of returns over the period in question could be between +25% and -15%. However, if the level of volatility was 5%, the maximum return would have been 10%, but there would have been no negative returns.
Investment in a single sector is usually more volatile (risky) than investing across a range of asset classes. By investing in a range of assets, such as equities, bonds, cash, property, precious metals, hedge funds, etc, this is likely to reduce overall volatility, because when certain types of assets are suffering, others are likely to be posting positive returns. This creates a “smoothing” or “averaging” effect. Hopefully this will generate a higher return than just keeping funds in cash, but there is no guarantee of this.
Because most people are risk-averse in the sense that the thought of losing money is more disturbing than taking risks to make large gains, most people would rather trade off some the risk for the benefit of security. Also, common sense dictates that if two different funds or investment portfolios offer the same returns but have different levels of volatility, you may as well go for the lower volatility option, as there is little point in taking on additional risk to achieve the same return.
You may ask “what is an acceptable level of volatility?” This differs from person to person, but a rule of thumb measure is that a range of 0-3% is definitely low risk (cautious), while anything up to 10% is acceptable for the average investor. Anything over 20% is getting into high-risk high-reward territory.
A final point is that of randomness. Whilst market surges and crashes do not usually appear out of nowhere, they do usually catch many investors by surprise (they literally “did not seeing it coming”).
This simulator uses a Monte Carlo Simulation to account for this effect of randomness. Such calculations rely on repetitive random sampling to compute a result, and are useful for providing outcomes where there is no absolute outcome.
You will need to enter a starting value (or transfer value) for the Drawdown Pension plan. This assumes that any tax-free lump sum has already been deducted, so you may need to deduct 25% of the actual pension fund year. You can then enter:
- An absolute level of withdrawals specified as a monetary value or
- A percentage of the fund based on the GAD tables.
The choice here is an important one, because if you input a monetary figure, this will use the same amount year on year, irrespective of actual GAD rates.
If you select a GAD percentage, this will use the true level of withdrawals permissible based upon the individuals age, gender and Gilt Yield Index. Because income limits are reviewed every three years, the level of withdrawals are recalculated based upon the higher age and fund value at that point.
This means that is absolute values are used, it is theoretically possible to run a pension fund down to zero by taking excessive withdrawals. By using the proper GAD percentage, the requirement for having three-year reviews means that it should not be possible to totally run the fund into the ground, because if there has been a combination of heavy withdrawals and poor investment performance, the maximum permitted withdrawal after the review should be significantly lower than before. This is an intentional mechanism to stop individuals pillaging their pension funds in the early years and then going cap in hand to the state for assistance.
Therefore, a more realistic calculation will be provided if you specify a GAD percentage rather than a monetary amount.
There is an additional option to further reduce withdrawals by an additional percentage if the fund falls below the value of the fund five years previously. This is because people frequently do reduce withdrawals when the value of the pension fund has been decreasing far more than expected.
Because this simulator uses an element of randomness, no two calculations will be alike. Therefore, it is more useful to run this several times to see the range of likely outcomes. By increasing the level of volatility, you will increase the range of possible outcomes.
Please bear in mind that this is a simulation, not a projection of pension benefits. A projection uses standardized calculations, so there should only be one outcome. In contrast, a simulation looks at a range of possible outcomes in order to work out what a likely outcome could be.
Use of this simulator does not
constitute a recommendation to use pension fund withdrawal. If you are considering going down this route, we recommend that you seek Independent Financial Advice in the first instance, as there may be more suitable options in your particular circumstances. If you are still in doubt, read through the consumer guidance sections within the Financial Services Authority
The figures projected by this calculator are only for guidance purposes - whilst we aim to ensure the accuracy of our calculators, we can take no responsibility for the usage made of the calculations generated on this site.