The Rule of 25

The rule of 25 says that if you want an income of £10000 you need to save a quarter of a million.

What? That's too much, haven't  you got ...

A rule of 20

Yes that would be...

Or 15?

Better.

How about 12?

Then I would only need to save half as much. So which one is right?

All of them in a way.....  x25 is not a bad estimate, but if you can live on 2/3 of your income that gets you to x15

No it doesn't it gets you to 16.66

Ah, but you don't pay national insurance  at 10% anymore. So maybe you can make do with x15

And x12?

If you have been saving  20% of your income, then you won't need the full x15, x12 will do.

Ah....where does x20 come in?

Thats how the government values pensions in payment. If you have a £5000 pension that counts as equivalent to £100 000 in value.

So what should I use?

Better go x25 for safety

But that means to get a pension of £10000 I will need to save..

That's right, a quarter of a million.

The big 4: how? where? what? when?

 You can't hope to know the answers without first figuring out the questions. And  even with plain vanilla personal finance there are four of them.  How? Where? What? When?

How much shall I save?  You need to save at least  slice of your income, preferably a chunk. A sliver isn't enough. [ A chunk is 2 slices, a slice is two slivers].  A slice is 8.33%. 

Its a piece of cake. A twelfth. A month's salary. Two months is good, three months great. Perhaps not coincidentally the new style UK  personal pension schemes will kick in at 8%. And the old style pensions rules used to limit tax relief to 15% of your income. Again that's saving around  1-2 months salary every year. 

Where shall I stash my savings? This isn't a what to buy? question. That comes next. This is about which tax regime? should my savings grow in. The three most popular are ISAs, pensions, and your home. Each has special tax concessions. 

ISAs have no further tax to pay, and a very flexible. Buying your own home isn't flexible, but there is no income tax [on the rent you save] and no capital gains tax. The pensions tax regime offers a tax free lump sum [25% of pension value] and tax deferment. On the downside it is the least flexibile. You can't access any cash until you are at least 55  [or 65 for men's state pension], and even then you can't get your hands on all of it.  

So you could stash all your savings in an ISA, or use it to pay off your mortgage early, and have very little to do with the pensions  tax regime even though you think of yourself a saving for your 'pension' [as in 'my house is my pension']. Governments like the pensions  (tax)  route because it limits you to when you can spend it [see the last question, below]. And the finance industry like it 'cos they can charge you fees. Of course home owning isn't a fee-free zone - as anyone switching mortgages can testify.

What to buy?  Is the traditional big question. The industry is ready with the answer: 'Buy our unit trusts, endowments , emerging markets funds....' by which they really mean 'pay our fees'. For vanilla investors this question is about your asset allocation. How much in boring assets [gilts and cash] and how much in bouncy  [shares and  commercial property].

When to cash in?  Even within the state scheme you can opt to delay your pension. Those with money-purchase pension schemes also have an additional question. Do I take an income (also known as drawdown) from my personal pension fund, while leaving it invested - or do I buy an annuity with it. Or can I do both?

Thats the questions - what are the answers?

It depends.

How much?

Lets look at what Robert  on £36 000 a year does..

Robert decides he can save £4500  a year  [an eighth - a month and a half's worth, not bad]. Over  35 years thats £250000 - [if the real interest rate after inflation is 2.5%, ie he ends up with  £250 000 in todays money].

Where?

Robert decides to pile it all into paying off his mortgage early. He manages this by his mid40s, and switches his savings into an ISA. There was a five year period when he did both - because he was worried his ISA allowance might not be big enough to cover all the savings he wanted to make in his fifties. He was hoping he would hit the 40% tax band, when he would have started saving into a pensions  wrapper because of the tax relief. But he never quite earned enough. And the standard tax relief wasn't enough to tempt him.

What to buy?

Robert just splits his fund equally between index linked gilts and shares [the FTSE 100] . He finds an etf [like a tracker] for each area. He only has two holdings. Its not ideal. He has no overseas holding. And gilt funds are not the same as gilts [the latter are redeemed - gilt funds aren't]; but compared to many of his friends he has done ok. Most of his money went to pay off the mortgage. His friends still have a mortgage - and a big hole in the value of their shares holding

When to take your pension?

Because Robert's money is in his ISA he can take the money out any time....  He doesn't have to wait until he is 55 - or be pushed into buying an annuity before he is 75. We'll come back to this later when we look at someone who has  saved/trapped all his money in a pension scheme.

Three questions

Brent, Homer and Richie each have a net worth of zero. Add up their assets, deduct debts: zilch.

1 Brent rents his flat: should he take out a loan to invest in the stock market?

2 Homer has a mortgage. Should he increase his mortgage to invest in the stock market?

3 Richie has a mortgage, and some shares. What should he do?

For the vanilla investor there is only one answer. You don't borrow to buy shares. Ritche should sell his shares and pay off the mortgage.

Vanilla in a nutshell

The personal finance industry is a drain on resources: yours.  Vanilla Finance came about as a way of saying to us ordinary punters: this is what you need to know and its not a bad plan [maybe not the best, but that is unknowable in advance].

Vanilla Finance says 

1 Own asset classes, rather than individual shares or loan stock. Passive investing.
2 Over a lifetime of saving, your asset allocation determines your outcome.
3 Work out an allocation that suits you, and stick with it unless your circumstances change.

Just as dieting can be summed up in a few words [eat less, exercise more], so can vanilla finance [index and rebalance]. Like dieting it can be hard to stick to the rules. Unlike dieting it gets easier the lazier you get. Rebalancing is the most active part, and that can be left for years [every two or three years still seems to work as well as anything].

Implicit in this approach is that professional managers [eg unit trusts] do not add value [some do, some don't, but you don't know which in advance].

Figures in the landscape
When I give examples I mostly use real [not nominal returns]; I also assume 1.5% advisor charges with funds, but only 0.5% with trackers and etfs. Benchmark returns [ie 'what if', not predictions] are 1% for gilts, 2.5% for corporate bonds, 4% for equities; an equity risk premium of 3% [until recently that was the on low side of the consensus]. They also give handy doubling times of 70, 30 and 18years which have a very human scale to them.

As befits vanilla simplicity I only have two asset uber classes. Boring and bouncy. Boring has reliable returns, 'bouncy' doesn't. Index-linked gilts, and shares are examples of each. 

In the simplest version of vanilla 'boring' contains' 3  asset classes: cash, short-term gilts, and index-linked gilts.  Bouncy contains: shares, overseas shares and commercial property.

Other asset classes, like private equity or timber turn up later; hedge funds never show up. Commodities have been shown the door but keep trying to climb back in through the window.

So the big decision comes down to the mix between boring and bouncy in your asset allocation. 

If you only make one decision in your investing life, this should be it. Once you have made it the rest is detail.

It's like mixing a cocktail. How much from the boring bottle - and how much from the fizzing bubbling bottle that hints at the promise of riches to come? A bit of fizz can be more fun, but it can also give you a headache in the morning [or worse, 40 years later on retirement].  The sheer weight of responsibility might make you hesitate before mixing up this cocktail of assets for your lifetime - but in fact you will have already done it. You have an asset allocation right now, its just you haven't checked out what it is.  The variations are practically endless - but vanilla suggests 3, as yet unamed, benchmark cocktails: 

adventurous 2:1; balanced 1:1 or cautious 1:3.

Note even the most adventurous allocation only has 67% 'bouncy' -  far short of 100% equities, and certainly nothing over 100% [which would be leverage with a loan]. The cautious cocktail has 75% in cash and gilts - once upon a time this was thought suitable for a 75year old...

So finally we get there: mixing up first a balanced cocktail we have 50/50:

20% gilts, 20% index linked gilts, 10% cash - the boring bit
20% shares, 20% overseas shares, 10% commercial property - the bouncy bit

There's enough of a kick from the 'bouncy' side to leave you a bit dizzy from recent market falls. And the strong hint of commercial property that added zest a few years ago, now just leaves a nasty taste in the mouth.

The cautious cocktail gives you

30% gilts, 30% index linked, 15% cash

10% shares, 10% overseas, 5% property

There's a hint of fizz and a lot of boredom. And right now boredom is in short supply.

You can get this coverage with trackers or etfs [eg ishares]. The contentious bit is there are no corporate bonds. Opinions differ as to whether they offer the best of both worlds or the worst. Vanilla is in the latter camp and recent events have confirmed it. Next year may be a great year for corporate bonds, but then it may be a great year for equities too.

Also overseas equities have a strong covariance [move in tune with] with domestic, so they ain't a great diversifier.  But as the pound has dropped overseas  holdings have been useful. Overall the 50/50 portfolio would have saved you from the worst excesses of the market slump.


So far, so what?

Well if you cut 1% off your charges, that makes a big difference. Chances are a disciplined approach will save you even more. Studies of what investors actually earn make for depressing reading. Money-weighted rates of return are very different from time-weighted. Money-weighted is the one you eat.  

Earning 100% on £50 is not much use. Next year you earn 0% having been encouraged to invest £50000. Your charts say you have earned a simple average of 50% a year. You would be the pin-up of the funds industry, maybe feature in their ads. But your spouse knows you have earned £50 over two years.

Also vanilla finance favours delaying paying into a pension fund until you can get a 40% rebate - and that might mean waiting until your 40s.

And last but not least vanilla finance says you can usefully use all your savings to pay down the mortgage - and forget the rest. Once the loans are off your back then you can start with the cocktails.

The man who had six pensions...

The pensions landscape is littered with forgotten tax breaks, misguided schemes and failed initiatives. Even the 25% tax free cashback rule  is the result of some long-forgotten compromise dating back to the 1930s. And over it all hover the birds of prey of the finance industry, looking for easy pickings. But all of us have to find a way through somehow - so what is the best path to choose?

Here's the vanilla guide to the key features.

Broadly there are three places to go to get a pension. And each offers two choices. That's six different pensions....

The big three pensions organisers you can look to are

• the government
• your employer or
• you can do it yourself.
  

The government provides the basic state pension, and also offers an additional state pension [ASP] that used to be called SERPS [state earnings related pension] and then became the Second State Pension. Savers could skip the ASP by contracting out. Recently the UK governments focus has changed to making sure we all contract in for an additional basic minimum. Their solution is the personal pension accounts from 2012, but these really belong in the 'employers' section.

Employers provide two kinds of pension schemes. The old style 'defined benefit' promised a pension based on number of years worked. Your pension savings didn't bounce around with the stock market. As long as your employer didn't go bust your pension was secure. Very nice to have but also expensive [for the employer], which is why 'defined contribution' schemes are taking over. Here your pension depends on how much money is in the pot when you retire. And that depends on how your savings have done. These are also known as money purchase schemes. Employers usually pay towards the admin costs of these schemes, and may add in their own contribution. Think of it as free money. 

Finally you can organise your own pension two ways too: by paying into a personal pension plan [ie from an insurance company] or by doing the whole thing yourself [a self-invested pension plan, SIPP].

So which is best?  Whatever's cheapest, most secure, and index-linked.

In first place:

Anything from the government is about as good as it gets [unless you are CEO of a failed bank]. The state pension is due to be indexed in line with earnings [not just inflation linked]. And if you work for the government, so much the better. [Better still for women]

In second place

Almost any 'defined benefit' scheme - because the good ones will have insulated savers from the roller coaster ride of 21st century equity markets. [Also good for women]

In third place

Anything with free money - eg where the employer makes a contribution. Or you can get national insurance rebates ['salary sacrifice'].

And languishing outside the medals is the whole of the personal pensions industry. It has to, almost by definition. It feels the full lash of market forces with no protective buffer [unlike defined benefit schemes, or those with employer contributions.]  But even here there is a winner.

In fourth place:

The SIPP - self invested pension.

Which puts the personal pension plan - the raison d'etre of much of the finance industry - firmly in last place.  Why? Because it charges the most with no discernible uplift in performance.

So what am I supposed to do?

Hold back on the traditional personal pension plan until you have checked out the other options

Which are?

Buying additional years if you can; seeing if employer will match any of your contributions; exploring salary sacrifice [national insurance rebates]; seeing if  your employer's additional voluntary contributions [AVCs] have low charges; start your own SIPP...

SIPPS are expensive

Yes they can be - but for the very simplest SIPPs set up costs and annual running costs can be under £50, or even zero. Google cheap SIPP. I got Hargreaves Lansdown, SIPPDEAL and Alliance Trust. But if you don't want to pay the  1.5% charges of managed funds [and vanilla investors don't] then be wary of HL -  they will hit you for 0.5% anyway [capped at £200] on other investments. Either way they are looking to get their 0.5%.

Does the odd 0.5% make such a difference?

Every year. Until you retire? Yes. You should aim to get all your expenses under 0.5%, under 0.3% you are doing well, under 0.1% and you are probably in a US government scheme. UK fund expenses usually start around 1.5% and in practice [by the time you buy, and then sell] will have exceeded 2% per year.

What about stakeholder schemes?

Capped at 1.5% expenses for the first ten years? Poor value. The government wanted to make the charges a flat 1% - and failed. That tells you something about the importance of the odd 0.5%.

Are women really better off in defined benefits schemes?

If you buy a pension for cash it cost about 10% more if you are a woman.

My friend's been a teacher all her life. She's retiring at 60.

If she is in the state system she will be ok

But she says she is only get £20 000 pa pension

That would cost £600 000 to buy. How may people save that much in their lifetime? Tell her to cheer up.

Is it true women get their state pensions early?

Up until 2020, yes. Are you a woman?

No

Would you like to be?

?

If you have a sex change and get a Gender Recognition Certificate you can claim your pension early.

I'd rather have a small pension and a ...

Just checking

Home truths about shares

Lets take a look at a very simple idea that leads to a very radical conclusion.

Remember the ABC portfolios? Adventurous had two-thirds in equities, Balanced had half, and Cautious one-quarter. The rest was in cash/gilts/index-linked bonds - the boring bit. None had 100% equities, certainly none had 150% equities, which is what happens when you borrow to invest. That is called leverage - yet millions of ordinary investors [that's you and me] are leveraged without even knowing it.

To understand it, first you have to realise that a loan is like a negative cash balance. It's exactly equivalent if savings and loan rates are the same. If you can say borrow £100 at 4% and deposit £100 cash at 4%, it is the same portfolio as having £200 loan and £200 in cash. It sounds obvious but it has very important implications.

Before we run with it - let's look at the two possible alternatives to this rule, where cash either pays more or less than the loan rate.

First, its unusual if you can borrow at 3% and invest at 4%. In this case cash and loans would not be equivalent in terms of risk and return and it would make sense to borrow as much as possible.... It would be a free lunch. Lest we forget, this is what ratetarts and banks try to do.

Second - and more usual - you might have to pay more for your loans than you get for your savings. That's why, in the real world it makes sense to pay off loans with any spare cash, because we will be charged higher interest on the loan than we get on the savings. The classic example is credit card debt.

However for today we will make them precisely equivalent - a loan is negative cash. Having cash of £200 and a loan of £100 is just the same as having £100 and no loan.


So now we have two principles

1 No leverage. [Don't borrow money to buy shares]

2 A loan is negative cash.

So far, so bland. But it means that:

if you have a mortgage you shouldn't invest in shares

Let's see how we reach this rather startling conclusion by looking at Trisha's savings.

She has a balanced portfolio £20 000 in cash/gilts and £20 000 in shares She also has a mortgage of £100 000. She doesn't realise she is living her [financial] life on the wild side.

Straightaway we can see that she could pay off £20 000 of her mortgage using her cash. A portfolio of £20 000 in shares and an £80 000 mortgage would be exactly the same as what she has now. And yet now she has her savings in 100% equities.

Trisha examines her 'new' but exactly equivalent portfolio and is profoundly shocked. 100% equites? Scarey - this is not where she wanted to be at all. In fact she realises that things are even worse than she thought. She has effectively borrowed £20 000 to invest it all in shares.

She sells her shares and pays down her mortgage. The new Trisha portfolio is now: zero securities, zero cash. But her loan[mortgage] is down to £60 000.

Note there are two stages in this argument.

1 Loan is negative cash gets you a set of portfolios that are the same .

Savings of £50k in gilts/cash, and a loan of £50k is the same as savings of £100k in gilts/cash and a loan of £100k. There's nothing to choose between them. They are equivalent. But that equivalence gives us a powerful new way of looking at your own holdings. By removing cash from your portfolio (by paying off your loans), you can see the underlying structure [in risk terms]. Is your portfolio really as safe as you think?

2 Borrowing to buy equites gets you a set of portfolios that have the same [net ] value, but a range of risk/reward characteristics.

A loan of £50k and £10k in shares is very different [in risk terms] from a loan of £100k and £60k in shares. But the net loan outstanding [£40k] is the same in each case. There are real choices to be made here for professional [leveraged] traders. For vanilla investors the choice is simple. We don't do leverage, so we don't borrow to buy equities.

Don't hold any equites until the mortgage is paid off.

Which is another way of saying that once you have built up your cash balances to where you want them (the 'emergency cash fund' much beloved of financial advisors), all your savings should go into paying off the mortgage.

The Vanilla Test

If you are still paying off the mortgage, but don't quite believe this rule - try the vanilla test:

Add up all your savings - and deduct them from your mortgage. You have now reduced your borrowings to the minimum. [We are assuming here that vanilla investors do all their borrowings from their mortgage account, there are no other debts.] Now decide how much do you want to borrow to invest? Ok it's a trick question - because you don't want to borrow to take a punt on the stock market.

Let's take a look at Terry. He has a £50 000 left on his mortgage, and savings of £20 000 all in a global commodities unit trust. Terry does the vanilla test. It comes down to this.

If he had a mortgage of £30 000 would he really borrow another £20 000 to invest in the stock market?

There is no doubt is Terry's mind, the answer is absolutely not. He sells his shares, and chops his loan back to £30 000.


Reasons why you might ignore this rule

1 Cash in hand. Some people like having extra cash around for an emergency fund. So they will have £10 000 in cash and a mortgage. Or they worry they won't be able to borrow next year [maybe they are losing their job] and therefore they should keep/take loans while their credit rating is good. So they hang on to £25 000 in cash rather than pay off the mortgage. Note this is not strictly breaking the vanilla rule - you are just switching your cash/loan balance around - you are not borrowing to invest in equities.

2 You want to pay into a pension fund - and you will miss the tax breaks if you don't. For the average taxpayer the perks of a personal pension [run by an insurance company say] are not that great. For a 40% tax payer they are a bit better, but you do lose flexibility [ie you can't get all your money out again as a lump sum, just an income once you are 55]. Also - you can pay in more later, when your mortgage is paid off, but maybe you worry you won't be paying 40% tax by then.

3 Your employer makes a matching contribution into your pension scheme. This may be well- worth having, even if it means diverting some mortgage repayment money.

In these cases you may want to break the rules and channel money from paying off the mortgage into pension saving. But don't fool yourself, you are borrowing money to do so. You are carrying more debt than you have to. You may in the end decide it is a good idea - but at least the vanilla test lets you make an informed choice. It would, for example, have kept anyone [who was reasonably sane] from buying a with-profits endowment mortgage.

Remember that in an endowment mortgage the amount borrowed does not decrease. Instead the excess mortgage payments made [after paying the interest charges] are invested. You are investing with borrowed money. It's a leveraged punt on the stock market, although I doubt if it was sold in those terms.

But let's look at a successful £100 000 20-year endowment mortgage a month before it ends. The stock market fund holds £100 000 - enough to pay off your mortgage. Apply the vanilla test and you discover you have ended up borrowing £100 000 which is now all invested in the stock market. Is this what you wanted? Probably not. All you can do is sit tight, be glad your fund has reached £100 000, and just hope the stock market doesn't crash in the next 30days.


Frequently Unasked Questions

Listen - this is all nonsense. I only borrowed money to buy a house

Wasn't it Gertrude Stein who said 'A loan is a loan'. [No, it wasn't, it was Greta Garbo] . Use the vanilla test to figure out how low your borrowings could be - and then ask would you really want to increase your borrowings to get back to what you have today. You might do - which is fine.

But surely a mortgage only applies to a house not to shares?

A mortgage just means there is security for the debt [in this case a house]. But even if the house became worthless - you would still have to pay back the loan. Don't think of the debt as being attached to the house - its attached to you.


I do have a mortgage - but all my savings are in a cautious managed fund. That's not leverage is it?

A typical managed fund might have 40% equities and 60%bonds. The equities bit is your leveraged bit. Because in theory [but not in practice] you could sell off just the shares and thus reduce your borowings.

So the bonds bit is OK?

It's OK but pointless. Why are you borrowing at 3.5% from your building society to invest in a bond that pays 3.75%. Because you can be pretty sure the management charges and expenses will eat up any difference. Chances are you are losing money on the bond side, and playing with fire on the equity side.

You've made my portfolio far too volatile...

No I haven't

Last year I lost 5% - this year after I did the vanilla test I lost 20% in the same market conditions

Last year you had £75 000 in gilts and £25 000 in shares. When shares dropped 20% you lost £5000. This year you paid off your debts with the gilts and started with savings of £20 000 all in shares. When the market dropped 20% [again] you lost £4000.

But I lost 20% - thats far more volatile

The share moves have been unchanged - its just that you can see them now clearly. Don't forget that the net effect is still the same with the new portfolio make-up [all shares]. The vanilla test has highlighted something you didn't spot before.

But should anyone with a mortgage sell off their unit trusts and trackers and ..?

Yes, it would be a start. In fact it should be the start. As in - 'you start from here, and decide if you want to add to your borrowings so you can invest more'. That way people will have their eyes open.

But every financial advisor tells me I must have some money in shares..
Yes, and maybe 3 out of 4 years theylook good because shares handomely outstrip the mortgage rate. But every now and again you will wish you had put your borrowed money somewhere else. Or maybe not borrowed any in the first place. It's your choice; but most people don't realise they are investing with borowed money.

But I have a 25year mortgage to pay off..
You will be surprised how much quicker it goes when you pour all your savings into it.

And then what ..I end up at age 49 with no savings, and my mate has £40 000 stashed away
Yup - but your mate may still have £45 000 to pay off on his mortgage

Yeah I forget. Still it feels funny having no savings..

It feels funny because what you have got is no debt. Plus you own your home free and clear - that's an asset.


Even so - if I don't have any shares I will miss out any market rises for the next ten years

Yes you will. You will also miss out on any market falls. But a market rise would test your resolve severely. Just ask anyone who didn't buy internet shares during the tech boom of 1996-2000, while their friends got rich with very little effort.

So maybe I could put £5k into shares....?

You could - but only because you are aware of what you are doing. If you have done the vanilla test and say - I don't care I still want to borrow that extra [ie not pay off] £5k so at least I have a stake in the stockmarket. Fair enough - but it is leverage.

In GAD we trust?

Spending is harder than saving. When you are saving you have a retirement date to aim at and you know how much you are saving every month. There is only one unknown: what your rate of return will be. Figuring out how much you will have saved up when you retire in 30 years time is not an exact science. 

But when you get around to spending your savings [aka drawing a pension] the uncertainty is even worse. There are now two unknowns - the rate of return, and how long you will need the money for. Put crudely: you know when you will become a pensioner, but you don't know when you will cease to be one. And that's why spending is tougher than saving.

It's enough to make most savers run straight into the arms of an insurance company - swopping their £100000 of  pensions savings for a guaranteed pension [an annuity] that will pay them around £150/week for the rest of their lives. Actually the average UK  pension pot is nearer£30000, but £100 000 makes the numbers easier.

The annuity route is known in the jargon as a 'secured pension'. The alternative is an 'unsecured pension' where you can leave it invested - in a SIPP for example.

So here's the problem: if you reach retirement and have decided not to buy an annuity [yet], how much of  your £100000 can you pay yourself each year as your unsecured pension? Remember it has to last a lifetime.

Well the government actuary's department has come up with a set of guidelines - known as the GAD tables. They are roughly equivalent to the rate of payment from an annuity. Just plug in your personal details [age, sex] and the current interest rate [last month's long-term gilt rate].

For Albert [male, gilt rate 4%] the GAD rate is 6% at 60, 7% at 66, 8% at 70 and 9% at 73. The bad news for his wife Beth is that she has to wait an extra three years to reach the same levels, eg women don't hit the 7% mark until they are 69.

So at the GAD rate Albert would take £6000 a year from his pension fund. Suppose he wants more? Well he can take more. Up to 20% more. [Don't ask why  - it is just what the government rules say you can do].

So Albert has a choice of taking anything between zero and £7200 from his pension fund - no matter how well or badly it is doing. He can take this income for 5 years without having it reassessed. But at age 65 - after £36000 has been taken from his pension fund and some poor stock market returns - you can see that Albert's pension pot may well have shrunk considerably. The GAD tables guarantee neither consistency not security in pension drawdown.

What's Albert to do?

The short answer is Albert should think about taking  out the absolute maximum he can - the full £7200 - and then save half of it [say in an ISA]. Because spending the full £7200 is not 'safe', where safety means having a guaranteed fixed income until you die.

Determining what is the safe withdrawal rate has spawned a whole industry in itself - but many people believe it is around 4% - giving Albert a fixed £4000 for life but still not guaranteeing it.

The other route to go is to take a fixed percentage every year - say 5% - of the value of your fund.  Albert would get £5000 this year but couldn't be certain what he would get next year. It might be more or less than £5000 depending on how his investments had done in the meantime.

In GAD we trust? Only as a means of working out how to retrieve the  maximum amount of money from the pension tax regime. As guidelines to a sustainable fixed income in retirement they are seriously flawed. Remember:  a 70- year old could take out £8000 a year. Five years later, and after a big market drop, there would not be much left of his original £100000 pension pot.

FAQ

I don't see the point of this - why even consider settling for a still uncertain £4000 a year from a SIPP when I could get a guaranteed £6000 from an annuity.

Because the SIPP money is still partly in your control [by withdrawing the maximum allowed you can get your hands on a lot of it]. And if you die a year later, your pension pot is part of your estate [taxed at 35%]. With an annuity all your money is gone. Also if you have a SIPP, you can buy an annuity later. But once  you have got an annuity there is no changing your mind.

How come the GAD guidelines let you take out 7%; and many advisors don't recommend going  above 4-5%.

The GAD guidelines treat your money the way an insurance company would - making it last for your expected lifetime [say 20 years at 65]. And then letting you take a bit more.  Mainstream financial advisors would pencil in the need to sustain 25, 30 or even 35 years of retirement income. And that hammers the pension you can take out of your pot. [Adding eight years to your retirement calculations, from 25 to 33, could cut your pension by 25%].

So would using the GAD guidelines make my pension pot get smaller?

Probably - but don't forget that is what they are designed to do. The guidelines allow you to receive a portion of your capital back every year. All the 'income' you receive will not just be interest or dividends.