Three kinds of 4%

Nowadays you don't have to buy an annuity with your pension pot - you can invest it and draw an income instead [often known as income drawdown]. This pot can still be used to buy an an annuity later [up to age 75] if you want.

So how much can you safely withdraw each year? Well the answer depends on your life expectancy and your future investment returns. Both are very uncertain, so much attention has been given to finding the 'safe withdrawal rate' even allowing for poor stock market returns, and increased longevity.

The standard answer is around 4%.

But there are three kinds of 4% withdrawal on - say - a $100,000 pot. (We are talking dollars here because its in the USA that this has been studied most).

1 Take $4000 a year index linked. So it goes up with inflation.

2 Take $4000 every year - flat rate.

3 Take out 4% of your pot whatever its size.

Option 1 is the toughest to maintain, option 2 is usually what is meant by the 4% rule, option 3 is the 'safest'. Where safety means you will never run out of money (although you might run short of money).

The vanilla pensioner goes for option 3, despite its drawbacks which are:

• your income will bounce up and down with the value of your fund; and
• it doesn't allow for the fact that as you get older, you should be able to withdraw a higher percentage from your fund

We will look at ways to fix this, without straying too far from the underlying philosophy: the size of the pension you can take depends on the amount of money you have - not on the amount of money you used to have.

And that is the serious drawback of options 1 and 2 - blithely taking $4000 a year even though your fund may have dropped to $60 000.