You’ve spent years building up your nest egg and now it’s time to retire, but the big question looms: how do I work out what income I can take from my pension pot?

People will have spent their lifetime building up their pension and are nervous of splurging too much of it straight away, while others will be over-optimistic about how much they can afford to take out in the early years.

To help avoid this experts have come up with rules, to help guide people on a sustainable income to withdraw from their fund. The most common of these is the ‘4% rule’, which has used lots of modelling to work out that 4% is a relatively safe withdrawal to take from your pot and not exhaust it too quickly.

Even if you use whizzy financial modelling of how long a certain income will last you in later life you’re at the mercy of markets falling in the first few years after retirement, and your capital becoming eroded. This is called ‘pound cost ravaging’.

When you take money out of your pension you sell down your portfolio to generate income, and when investment values drop, you need to sell a higher proportion of your portfolio to generate the same income. It means you’re depleting your portfolio more quickly, and also makes it harder to recover from any losses.

A good example is to look at a single fund that has seen its unit price drop from 100p to 90p. If you wanted to take £500 of income you’d need to sell 500 units if the price is 100p, but you’d need to sell 556 units to generate that same £500 of income if the unit price was 90p.

This is why a new book, Your Retirement Salary, has devised a new method, called the 1% rule. Rather than relying on cashing in units or shares in order to fund your income, the authors instead suggest focusing on dividend-producing assets and getting the bulk of your retirement income from there. To supplement this you take 1% out of your pot each year.

‘The “1% rule” is intended to build on the idea that you could withdraw 4% of your pension a year. We hope it will reduce the risk that people will take too much out of their pot at the wrong time and do irreparable damage,’ says Richard Evans, one of the authors of the book.

POINTS TO CONSIDER

But there are a few important things you need to remember when taking this 1%. Firstly, it should be 1% of the original value of the pension pot, not 1% of the value it has reached each year.

Secondly, the authors recommend you sell 1% of each holding you own, rather than just taking it from the investments that have risen most throughout the year. This might seem counterintuitive, but it’s crucial to being able to generate income at the same level, the authors argue.

As you’re relying on these investments to produce an income, you don’t want to deplete the units in any single fund too much.

‘This preserves the income-producing potential of each fund and avoids having to take a bet on which ones are likely to perform better in the future. It also means that you are preserving the overall portfolio’s original division of income-generating potential between the various types of assets,’ Evans states.

WITHDRAWAL FREQUENCY

The third aspect to take on board is ensuring you don’t withdraw this 1% too often. Many people are used to receiving a monthly salary, and so want their pension income to replicate that. But if you withdraw this 1% annual amount each month (so 1/12 of your 1% each month) you’ll incur trading costs that will likely eat a big chunk out of your pension income. It means you’ll effectively be wasting some of your income on unnecessary fees.

Instead you should aim to take the money either annually or, at most, quarterly. The latter still gives you four regular payments throughout the year, but means that you’re only incurring selling costs four times a year too.

HAVE CASH IN RESERVE

The fourth element to the 1% rule is having a cash pot to hand, for emergencies or to dip into if needed. Even when you’re working and have a regular monthly income, it’s advised that you have a cash pot worth around six months’ expenses, so that you have a fall-back in an emergency.

You should adopt the same approach in retirement, and ensure that you have a sizeable pot of cash to avoid having to raid your investment pot should you have unexpected expenses.

Taking an unplanned, sizeable withdrawal from your pension portfolio could eat into your future income dramatically, particularly if the withdrawal occurs when the market has fallen.

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