Generate your retirement income the Warren Buffett way

Managing your pension is, like football, a game of two halves. In the first half, your working life, you save money into the pension; in the second half, retirement, you gradually take it out.

The saving phase can be relatively straightforward, especially if your employer handles everything. But the withdrawal phase, which is sometimes called income drawdown, can be extraordinarily complex: a balancing act between maximising income, minimising tax and ensuring that you never run out of money.

Not only do you have to decide how to invest the money in your savings pots while you’re taking an income from them, you also need to determine how to divide your withdrawals between ISAs, pensions and other savings, how to use your entitlement to tax-free pension lump sums to best effect, whether to put some or all of your money into annuities and if so of what type … the considerations spiral almost limitlessly. Alighting on the perfect solution when there are so many permutations can seem impossible.

It’s little wonder that friends and acquaintances, even some who work in the City, express exasperation. One even said he was postponing retirement because deciding how best to make pension withdrawals was so difficult.

To help you navigate this thicket of complexities, we plan a series of articles about this second phase of your pensions life (which sometimes goes by the ugly industry term of ‘decumulation’, to contrast with the ‘accumulation’ or saving phase). Our aim will be to simplify the process as much as possible.

Warren Buffett to the rescue!

In that spirit, for our first article we will enlist the help of the world’s most famous investor, Warren Buffett, who is admired not only for his impressive investment record but for his ability to express profound truths about investing in everyday language. No one has done more to make successful investing simple.

While Mr Buffett cannot help us with the specifically British aspects of the problem, such as navigating our tax system and making best use of ISAs and SIPPS, he most certainly can help us with the question of how to invest money in retirement so that it will produce the income you need.

And a decade ago he told shareholders in his company, Berkshire Hathaway, exactly how he would do it.

In one of his annual letters to Berkshire shareholders (those letters, available here, make useful reading for any private investor, by the way), he spelt out the instructions he had given to the trustee who would manage the money set aside for his widow’s upkeep after his death.

Here are those instructions in his own words, taken from page 20 of his 2013 letter to shareholders: ‘My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)’

Don’t be put off by the ‘short-term government bonds’ – they are effectively cash. Short-term means that they are close to maturity, so holders will receive a known amount of money on a known date not far in the future. This is the same outcome you get from investing a sum in a fixed-term savings bond from a bank or building society (it’s only long-term government or corporate bonds that are at risk of serious price fluctuations in the market if you need the money before maturity). So for the 10% we can simply read cash.

For the other part of the Buffett portfolio British savers could take the advice of the ‘Sage of Omaha’ literally and buy a Vanguard S&P 500 tracker (a Fidelity Select 50 fund) or a rival offering from UBS; alternatively they could decide to stick with their home market, and thereby avoid the effects of currency fluctuations, and buy a UK equivalent, such as a fund that tracks the FTSE 100 or, for closer to the diversification offered by the 500 stocks in the S&P index, one that mirrors the FTSE 350 index of London’s 350 largest listed companies.

Why did Mr Buffett recommend this simple portfolio of 90% shares and 10% in what amounts to cash? As far as the stock portion is concerned, he is unequivocal: the stock market produces the best long-term returns. When it comes to the cash, we need to think about the particular circumstances of those who depend on their investments for retirement income. Very often they will pocket the regular dividends they receive from those investments but supplement them by selling a small portion of the investments themselves each year.

There are two reasons for this. First, if you only take the natural income, your capital is likely to be largely intact, or even to have grown, by the time you die. While this will suit some savers who want to leave significant assets to their family (a less viable approach in any case for pension money after changes announced in the Budget), others will want to use every penny of their savings to boost their own income in retirement.

Second, the ‘natural’ income from dividends (or interest income from bond investments) may not be enough to fund the saver’s needs. This would be especially true in America if you chose to track the stock market: an S&P 500 tracker fund currently yields a fraction over 1%, largely because Wall Street is dominated by highly valued ‘growth’ stocks. (A FTSE 100 tracker yields more, currently about 3.5%.)

A dividend yield of 1% will be insufficient to fund retirement unless you have an enormous pension pot and to rely on those dividends exclusively would be to ‘waste’ the other element of financial return from your stocks, namely the growth (the same is true, if to a lesser extent, for the 3.5% yield from a FTSE 100 tracker). The way to use that stock market growth to help fund retirement is to make small regular sales of your stock market holdings.

But such sales bring their own dangers in certain circumstances. Let’s imagine that your income needs in retirement are £2,000 a month and that the ‘natural’ income from your dividends is £1,600 a month, so you need to generate another £400 a month by selling a small fraction of your investments. Now let’s imagine that there is a sudden and severe fall in the market of 25% – a distinct likelihood over the course of a long retirement (Forbes, the financial publication, says bear markets, defined as falls of 20% or more from previous peaks, occur on average every five and a half years).

If the market did fall by 25%, to generate that £400 income top-up you’d need to sell a lot more fund units; 33% more to be precise (if the price of your fund units falls from £4 to £3, you’ll need to sell 400 ÷ 3 = 133 compared with the previous 100 units). Not only does this mean getting a poor return from the units you’ve had to sell but you are eroding the dividend income from your remaining portfolio more quickly than you would otherwise because the number of remaining units is shrinking more quickly. This could lead you to sell even more units to maintain your income and could in severe or prolonged downturns create a destructive spiral.

This is where Mr Buffett’s 10% cash ‘buffer’ comes to the rescue. It’s there to provide an alternative source of top-ups for your natural dividend income, so that you are not forced to continue to sell assets while their prices are depressed. How long the buffer would last would depend on how much of your total income depended on the regular sales of fund units, but I would expect it to last several years for most people. Few bear markets last that long (research from LPL Financial, an American wealth manager, suggests that they last 11 months on average and take a further 19 months to regain former peaks), so the cash reserve should be enough to tide you over until the market recovers most or all of its losses.  

If you are in doubt, it may be best to seek help. The government’s Pension Wise services offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

Important information: - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA or SIPP and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a SIPP will not normally be possible until you reach age 55 (57 from 2028). Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment.  If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.