How a short pension can help early retirement around 55, and why annuities deserve a better press

One of the dilemmas facing the early retiree is how to minimize taxes. The extreme early retiree (<45) doesn’t have much choice but to pay tax on their savings to retire between their extreme early retirement date and the time they can draw pension income. You can avoid paying tax on the way in to a pension, but ISA savings are from tax-paid income. Now that Osborne has made pensions more attractive by improving their flexibility,  people need to start thinking how they are going to phase taking their retirement funds. That’s something you need to think about in you early to mid forties; at least ten years before the planned date of retirement.

I got a few of these things wrong, because I brought my retirement plans 8 years forward over a period of three years. In particular, consider very carefully whether you want to pay off your mortgage before retiring. Although I did, a mortgage is a flexible and low-cost loan. For most people not paying it off until you receive your pension commencement lump sum at 55 is the correct route, because it lets you smooth your income profile. Pay the mortgage down while you are working and before 55 and you will be better off in the long run but will probably take a severe income suckout in the gap between retiring and 55

There has to be the usual wealth warning – pensions are still complex, and people’s circumstances goals and risk profiles will vary a lot. DYOR and/or seek independent financial advice.  This is a tour of some of the high-level stuff. the devil is in the detail with pensions, but high-level stuff makes orientation easier.

Planning for slightly early retirement (55 and up)

In principle, planning is relatively easy for someone retiring after the Government’s mandated earliest DC pension drawing age, currently 55 but probably rising for anyone who is currently younger than 42. You basically save into a personal pension aiming at your annual desired retirement income * 20 by the time you are 55. I said the planning is relatively easy, doing it isn’t! Then you start drawing down the pension. If you want to leave it to your children after death then you carry on in drawdown, but if you don’t you can get some security against outliving your savings by keeping an eye on annuity rates as you age, and switching to one when the annuity return in terms of annual income gets above your investment return (~5% usually). This is usually around 65-70.

Planning for early retirement (45-55)

The planning gets harder for someone retiring before the Government’s mandated earliest retirement date. You have to save up from taxed income, preferably in an ISA. That’s been made a bit easier with the increased limits. Anybody who is in a position to retire early is different from the general working population, usually in earning more than average and probably also in spending less than average. Somewhere you need to open up a spending-earning gap. Unless you can get your spending down dramatically you’ll probably be paying higher rate tax on the money as you earn it to save across the gap

The same applies to me – all the money I’ve saved into my ISA and all the cash savings I have are from taxed income, and I was under the impression that once you’ve paid tax, that’s it. You don’t get to claw it back years later.

After the Budget changes, that’s no longer so. An early retiree’s tax status changes from

status	tax	NI	age	income from
working	x	x	< retirement	work
retired, pre-pension			<55	savings
retired drawing pension	x		55+	pension

One of the advantages of a DC pension is you can choose how much to draw down each year. You take 25% of the total pension capital as a tax-free pension commencement lump sum. Many people blow this on a holiday or other splurge, each to their own.

recommended splurge target these days

Some use it to discharge their mortgage on retirement, which has a hell of a lot to be said for it. But one of the other things you can use it for is to reduce the amount you draw down from the pension at the beginning, to less than the personal allowance of about £10,000

Such an individual’s stages look like this

status	tax	NI	age	income from
working	x	x	< retirement	work
retired, pre-pension			<55	savings
retired drawing pension + PCLS			55-60	10k pension DD + PCLS “DD”
retired drawing pension	x		60+	pension

That way you get a few tax-free years out of your pension. Note that I have made the assumption of at least a £250,000 pension capital, because drawing > 10k p.a. from any smaller amount would be unwise[ref]The PCLS takes it down to about 200k, and 1/20th of 200k is 10,000[/ref]. If you are drawing less than the personal allowance then you aren’t paying any tax on your pension unless you have earned income, in which case why are you drawing down your pension – ask your financial adviser about taking the PCLS from a DC pension at 55 and elect to draw down nil for a bit 🙂

It’s one low-risk way of improving your income from the pension, though investing the PCLS using an ISA and giving yourself a permanent tax-free increase in income is a good alternative. This is the one I have to take, because when I crystallise my pension I get both the income and the PCLS at the same time.

A change in tack for a pre-pension retired Ermine

That retired, pre-pension phase before 55 (or whenever you take your main pension income) is where you are living from savings or ISA income. It is precious, because you are a non-taxpayer. And there’s an opportunity opened now for you to claim some of the tax you paid on your savings back, indirectly 🙂

Non-taxpayers can save up to £2880 into a pension each year, to which the Government adds basic rate tax of 20%, ie £720 on £2880. You paid the tax when you saved the money in the first place. It’s a straight 25% gain[ref]the missing fifth that the taxman stole from you when you earned the money is returned, which is 1/4 of what you pay into the pension, hence a 25% bump-up[/ref]. If you do this for four years you will end up with a capital amount of 14400, for an investment of 11520. It’s a five for the price of four offer, though your first year’s contribution will have depreciated in value by about 12% due to four years of inflation[ref]my illustration is a bit pessimistic on that because it doesn’t discount end effects. For instance if I put in £2880 at the very end of the 2013/14 tax year, ie now, then presumably that cash has been earning interest for most of the year, so there are only two years and a month for inflation to erode it to mid-April 2016 when the operation ends. Likewise my last contribution goes in after April 2016, as soon as it’s gained the 2016 tax bung I close the SIPP and take the cash out[/ref]

You won’t get a 25% real return because charges are high on SIPPs – these plus the effect of inflation halve the return. I’ve computed this for a TD Direct SIPP. This isn’t the cheapest place you would go – a stakeholder pension from Cavendish is better value but TD already know me and I am hoping they will open the account before the weekend, so I can put in £2880 for the year 2012/13. The extra £720 HMRC will add (less the £345 it will have depreciated due to inflation by 2016) still makes it worth paying over the odds for. If they can’t get their act together then I’ll use the cooling-off period to back out and go to Cavendish with a stakeholder later on next year.

Charges and costs with a TD SIPP for 4 years

					total
inflation	3%	3%	3%	3%
tax year starting in	2013	2014	2015	2016
pay in	2880	2880	2880	2880	11520
tax added	720	720	720	720
TD open charge	0
drawdown cost
flex dd reg	75
close	75			90
annual (£40/0.5%)	40	71	142	211	704
running total	3560	7089	10547	13936	13846
profit	680	649	578	509
running profit	680	1329	1907	2416	1462
inflation depreciation	86	86	86	86	346
		86	86	86	259
			86	86	173
				86	86
total lost to charges					704
total lost to inflation					864
roi					13%

All the charges and the effect of inflation reduce the return to 13%, but it is a return without exposure to the vagaries of the stock market – just open your SIPP and either leave a lump of cash in it or use a money market fund that is sort of like cash. [ref]That is a stupendously crazy way of using a normal SIPP over decades, but for something that’s only going to be there for three years I don’t need to take stockmarket risk, though I will if a market swoon presents itself in that period[/ref] I would be able to take £3461 as the 25% tax-free lump sum and withdraw the remain £10384 as income without paying tax as the tax threshold should hopefully be at £10500 by the 2016/7 tax year.

There was a load of bellyaching from DB pension holders that they got nothing from Osborne’s changes. If you are a DB pension holder so crazed as to even think about transferring out to DC then stop right now and take a cold shower. To be honest, if you have a DB pension you should STFU and celebrate your good fortune in life and salute any tail wind that can help people out to make a DC pension work better for them. If you want to get the benefit of Osborne’s changes then you know what to do – damn well get out there and buy a DC stakeholder and stop whingeing.

Which is exactly what I am trying to do. I tip my hat to commenter Boardgamer who clearly located the on-switch of his brain a bit quicker than I did after hearing Osborne’s changes 🙂

Annuities, schmanuities…

Annuities have come in for an awful lot of stick recently, much of it unfair. From pensions A-day in 2006 nobody has had to take an annuity on retirement, only after they reach 75, and annuities are a hell of a lot better value at 75 because life firms figure you have one foot in the grave, and they know they’re paying out for fewer years than if you are 55. The screaming about annuities is only because people holler at their financial adviser that they want it SAFE AS HOUSES, not in the BIG BAD STOCK MARKET where their capital value marked to market MAY GO DOWN. CASH NEVER GOES DOWN – I WANT SAFETY.

Be careful what you ask for. Safety, and insurance, costs money. That’s why annuities are so shit at 55 or 60. So don’t be a nutcase. You entered the stock market over years with your pension savings. You will have lifestyled your pension savings to reduce equity exposure as you come up to retirement. But if you are retiring into a world where the stock market goes down and stays down on its knees from the long-term CAPE10 trend for 10 years then that is a world where you’ve probably got bigger problems than your pension. Starving hordes running through the streets, lack of clean water, that sort of thing. That’s not a country for old men…

All the scaredy-cats will say BUT THAT’S WHAT HAPPENED IN THE DOTCOM BUST

even this mahoosive FTSE100 chart doesn’t manage to span an Ermine’s shortened career. And it doesn’t show dividend income.

Well, yeah, but the dotcom boom was way above the CAPE10. People retiring in Feb 2003  had been putting money into the stock market for the previous 30 years[ref]probably using ghastly with profits funds and shocking fees, but that’s a different problem, and has been largely solved now by regulation[/ref].

Yes, they retired with an inflated idea of what their savings were worth, and the guys retiring three years before got a much better deal if they annuitised on retirement. But they didn’t lose out – they got damn good value from their savings, assuming they saved at a high enough rate, targeting the right capital amount. They’d have seen a big overshoot in 1999/2000. Maybe they should have taken the hint and retired then. Or if they had lifestyled their pension savings (transiting to an increased bond allocation and downplaying equities as they approach retirement) they wouldn’t have seen much of the boom, but then even less of the bust.

In short, do it right, guys. This information isn’t secret any more, and is standard financial advice 101. I lost a shitload of money in the dotcom bust, because I started in ’97. If you retired in 2003 you probably were in your peak earning years from 1993, and were buying tons of cheap shares from the 1973 oil crisis onwards[ref]Current savers should note there is a school of thought flagging up that expected stockmarket returns may be lower in coming years than historically. The FCA has mandated change to low, mediaum and high projected returns on pensions from 5,7 and 9% to 2,5 and 8%[/ref]. You didn’t lose out that much overall. And you did much better with 30 years of pound cost averaging than a wet-behind-the-ears ermine buying over three years at the peak of the market then running into index ISAs 🙂

Annuities aren’t inherently bad, just stop buying the suckers as soon as you retire. Consider  a mix of drawdown and annuitise when you’re older. Nobody’s had to buy an annuity on the date when they retire for a long time. People say annuity rates keep on dropping. Yes, annuity rates for a new annuity at 60, say, are dropping. If you know a way to be 60 this year and still be 60 next year you’ve got hold of a secret that is worth a hell of a lot to a lot of people, you don’t need a damn annuity. The annuity rate for YOU as an individual will improve as the years roll by ‘cos you ain’t getting any younger[ref]it is possible to invent scenarios where this doesn’t happen, but your personal annuity rate will increase at an accelerating rate as you get older, the cross-point may shift from 65 towards 70[/ref]. You can test this with any annuity calculator. Tell ’em your age and see the rate. Then tell ’em you’re 10 years older.

People often blame annuities for a very different problem. Not saving enough money. We are starting with a capital value of roughly 20 times the annual desired retirement income, yes? If not, you’re gonna have to stay at work until State Pension Age or start robbing banks until it is 20 times your desired income…

The trick of delaying annuity purchase only really works for people who retire normally, say at 60. If you retire with a pension capital of 20 times the desired annual income and your age related annuity rate improves enough to save your tail at 70, then you’ll have half of your capital left. You’ve been running it down for 10 years if your capital keeps up with inflation and you use a safe withdrawal rate of 5%. Do that for 20 years starting 50 and you are outta cash by the time an annuity can help you. Early retirees have to be more conservative with their withdrawal rate because they are exposed to risk for longer. They need to avoid running down their capital too fast.

Annuities are a tool, often used in the wrong place – at retirement. You are swapping stock market risk for inflation risk if you do that, because few people have saved up enough to eat the answer of “what is the rate if I tick the inflation-linked button”. The value of money halves about every 15 years due to inflation, so most people will get to see that.

The other place annuities get a bad rap is you can’t leave them to your kids when you die. Diddums. One of the few benefits of a DC pension compared to a DB pension is you could leave the unused capital to your kids  if you croaked before 75 and hadn’t taken an annuity. Now you can leave it to your kids even if you live to 105 or more. Your job now becomes saving up enough money that you can live like old money – off the income from capital, not running it down. You need to work for longer to save up more if you want to feather-bed your offspring, it’s as simple as that. Osborne has given you the possibility, Now do your bit – spend less than 1/30th of your pension capital in retirement and you have a better chance than the 4 or 5% commonly regarded as a safe withdrawal rate..

Your Risk Profile

FinaMetrica sums up the problem space well

Many financial decisions are made in situations of uncertainty, and so risk is involved. Different people are comfortable with different levels of risk.

Unlike, say, height or weight, there is no unit of measurement for risk tolerance. A person’s risk tolerance can only be measured relative to others on a constructed scale, in much the same way as IQ is measured.

By using the FinaMetrica Risk Profiling system, you obtain an accurate assessment of your risk tolerance in terms that are meaningful to you and your advisers. Your Risk Profile report will guide you and your advisers in your financial decision making. In particular, the report provides the basis for your instructions to your advisers on the level of risk you would prefer.

The reason annuities matter is that when people come to retire and take a DC pension, they are faced with a major life change. I have been through some parts of this, but many things are softened for me because I have a DB pension that I could live on if I took it now.

You retire in your 50s at the earliest, well, as far as retiring on a DC pension and getting to take it. For many people in their 50s, if you give up your salaried job you will find it very hard to find another one at the same level of pay. The reasons for this are complex, but generally

• you have experienced notable career progression
• 50 is an early time to retire, not many opportunities arise where firms would want to replace someone of that age with someone of a similar age
• you are more settled housing-wise but still often have dependent children, so moving is more of a wrench, meaning you have to look locally, restricting opportunities
• your experience fits a particular organisation, for instance although my general knowledge of engineering has a wide application elsewhere in industry a lot of my skillset is specific to The Firm, which is busy trying to get rid of its old gits. It’s definitely not hiring any more on the payroll 🙂

So retiring is a big move, it’s often a one-way ticket, and it’s stressful, even if you have enough money. People get fearful and conservative when in an unfamiliar stressful situation. And then your independent financial adviser walks along, glad-hands you, and sits you down with a cup of coffee. Then he says to you, right, Mr Retiree, how do you feel about risk? Say I were to tell you that the value of your stock market investments could fall 50% in one year, but it would probably not stay down. Well, he doesn’t actually do that, he opens his PC and gets you to do something like this online risk asessment or this Finametrica test

So there you are, you’ve just had the send-off from your workmates, you are going to enter a new phase of life, you have butterflies in your stomach, and now someone asks you how you feel about losing money, bearing in mind you aren’t going to be earning any more for the foreseeable future and probably the rest of your life. And what most people say is

HATE IT HATE IT, NO WAY.

What is this stock market you speak of that can chew through my money like that? Why would I give it house room?

So the IFA closes the laptop, looks you in the eye with an easy smile, and says Right Mr Newly Retired, that’ll be an annuity for you, Sir. Then goes through the spiel, looks on the open market and off you go with an annuity, and almost zero stock market risk. And I find that for an Ermine, for every £100,000 pension capital I can buy about £5000 as a level annuity payable annually from age 55.

No I don’t actually think that rate is too bad. It’s not a billion miles away from the 5% safe withdrawal rate from a stock market investment, and you’ll never outlive it. Trouble is, that every 15 years the value of this pension will halve. There again, 12 years after I am 55 the state pension will kick in, so the first bullet will be dodged[ref]How much that will help you depends on your pension income. If it’s £5000 then it’s a massive uptick. If your pension income is £100,000 then it’ll be lost in the noise[/ref], and that is inflation-linked to some extent. Now if I tell them I am grizzled of fur, 10 years older and I’d like it paid from 65 I get £6000 as a level annuity. Take a spin round the clock again at 75 and I’m good for £7500. Which was roughly the logic of why you had to buy an annuity at 75 at the latest; it’ll still be a damn good idea if you are a little bit short of money.

Talking about the risk assessment, in the interests of honest journalism I took a couple. And discovered I might have been rather too hard on the scaredy-cats, because it is possibe this looks very different to me. You can take the Finametrica test yourself at no charge. FWIW this is my result

An Ermine’s risk profile I’m not having you on with April Fool – Finametrica is an Aussie company and they are 10 hours ahead of us

It’s lethal, more than one standard deviation away from the norm. I took the Scottish Widows one

Your Details

Name : An Ermine

Results

Attitude to risk: Very Adventurous

Score : 84

The chart on the right shows where your attitude to risk fits:

About Very Adventurous Investors

Very Adventurous investors typically have very high levels of investment knowledge and a keen interest in investment matters. They have substantial amounts of investment experience and will typically have been active in managing their investment arrangements.

In general, Very Adventurous investors are looking for the highest possible return on their capital and are willing to take considerable amounts of risk to achieve this. They are usually willing to take risk with all of their available assets.

Very Adventurous investors often have firm views on investment and will make up their minds on investment matters quickly. They do not suffer from regret to any great extent and can accept occasional poor investment outcomes without much difficulty.

Yeah, right guys. Flattery will get you everywhere. FWIW I tried to be reasonably honest with the questions, though I did veer a little on the steady-as-she-goes when in doubt. It amazes me that I am such an outlier, more than one standard deviation off the mean. People normally get more conservative with risk as they get older, according to FinaMetrica.

The important thing here is that you should take one of these before your IFA does your pension, so that you have some chance to inform yourself about the options. Because otherwise our newbie testee, when faced with a whole load of questions where he doesn’t understand the question never mind the answer, will always go for the safe option. It may not reflect his views if he were better informed. This is a big decision, and if what you say points at the annuity way, you only get one shot. There’s absolutely nothing wrong in that, but it should reflect your view of the world, not your unawareness of the concepts. Oh and don’t pump up the answers just to make yourself look hard. It’s you who is going to have to live with the consequences. IFAs reckon that most amateur investors invest way above their risk tolerance. They would say that, wouldn’t they as they are talking their book. Nevertheless, when you look at the way private investors run for the exit just after a market crash they may have some point.

There’s probably also a good case to be made for you having run an ISA or a SIPP for about ten years before your retirement date, where you have some skin in the game – ie losing half the value would spoil your week, though not ruin you.

That way you get to see what a market crash looks like. You may think that you’re hard and can sanguinely whistle a dancing tune while there’s red all over your screen and where it said you had £200,000 yesterday it now says you have £100,000 and would Sir like to sell? If your feverished hands reach for the YES, DO IT NOW before I lose any more money button then you are not the Right Stuff. If it’s the ‘away with ye,  take me to the screen where I can add more money from my debit card and take advantage of this mayhem to buy low’ then you are probably the Right Stuff.

That’s the long story of why annuities have such a terrible name. They’re still right at times for the timid and may help those who are a little short of savings.