Avoid these mistakes in retirement - UK guide

So, I’m not yet at the age at which I will start to draw down my pensions, but it isn’t far off. Less than two years, and I’m spending that time getting my finances in order. And it is a remarkable testament to the algorithms used by things such as Instagram and Facebook, how regularly I am inundated with adverts telling me how to avoid certain costly mistakes in retirement. Click here for our report (it will say).

Believe me, this was of interest, even momentarily distracting me from amusing reels of kittens eating ham from forceps.

So I opened a few of them, and in all cases, what happened was a request for name, address, e-mail and phone number, and before I knew it, I was having to politely explain to Gareth, or Lucy or whoever, that I didn’t want their financial adviser to call me and discuss moving my savings and investments to them, and could they just send me the report as I had asked.

Well, sometimes there was no report, and when there was, it didn’t ever contain much of interest. I’m a UK tax resident, so what follows is mainly for the benefit of other UK residents. But the advice tended to revolve around keeping your investment portfolio as large as possible, or even growing, in order to maximise the fees of the financial adviser, not to make your retirement any easier.

And before I go too much further, my experience of IFA’s (Independent financial advisers) is a rather mixed one. They seem fine when you are working and too busy to manage your own finances and putting money into your pot each month. But as soon as you start to near retirement age and start asking questions like, “How soon can I start drawing this down?”, their behaviour changes. At that point, you begin to wonder, do they know that this is your money, and not theirs?

And let’s be clear, there is a lot of guff written. Even the FT the other day had an article about how the “4% rule” may no longer be appropriate for those managing a Self Invested Pension Portfolio (SIPP). My thoughts on the 4% rule are probably too rude to publish here, but are basically, that this is far too simplistic to use to manage your retirement.

Suppose you are single, with no dependents. You have a pot of £500,000. Your goal, surely, is to leave not one penny to HMRC at the time of your death? Now, that might be a tough calculation to make, and it is why you may think an annuity is the way to go. And for some, maybe this will make sense. Annuity rates are high, thanks to the period of inflation we have just been through. They will pay you a constant income for the rest of your life. But if this is your only source of income, and you are in good health, then maybe this isn’t the only pension option you should consider. For one thing, even if inflation runs at the government’s target of 2%, and the likelihood is more that it will exceed it on average over your retirement, then the spending power of that pension will drop - dramatically.

For example, if you are 60 now, and getting what you think is a decent retirement income of £30,000 a year, ask yourself what it will buy when you are 80. And for an average inflation rate of just 2.5%, a smidgen over the Bank of England’s 2% target, your income will by then be worth just over £18,000. And that would be a fairly benign inflation scenario. You could of course opt to inflation-proof your annuity, but when you do that, you won’t get anything like the £30,000 you were getting under the un-hedged annuity. There is a steep cost to inflation heading. This isn’t to rule out annuities altogether, they may make make sense at some point in your retirement. But maybe don’t put all your eggs in one basket - you wouldn’t do that with any other portfolio, so why now?

Another reason to spread the load, and this is one that most financial advisers don’t have much to say anything about - though they really should, is tax. In my case, I will get a small occupational pension at 60, and when I am 67, I will get the state pension, which by then will be about £15,000 depending on what happens to earnings, inflation and of course the triple lock (probably gone by then). But what this means, is that I can only “earn” about another £25,000 from all other income sources before I hit the higher tax rate on income, and at that point, I become a higher rate taxpayer on any savings interest that is also classed as “income”, and any dividend incomes, or perhaps some rental income from an investment property, and I also start to pay a higher rate of tax on capital gains on any realized investment income. So If I were an IFA, I’d start with this. How do you avoid being a highe rate taxpayer in retirement - it isn’t as easy as it sounds.

One way is to take advantage of tax free instruments. But it turns out, that there are virtually none of these any more. Most of the loopholes have been closed. The ISA is still a useful tool though, despite recent unhelpful tinkering in the budget. Hopefully you have been using this tool during your working life, and have a decent ISA pot built? In retirement, you can stop accumulating gains, and make it start paying out an income instead. That’s tax free - make use of that to top up whatever taxable income you are getting. You can still invest into a pension, and lower your tax liability. But as your earned income falls, the limits to which you can do this will also fall, so read the small print on the HMRC site to see how and if you can use this to lower your taxable income to keeop within the lower threshold.

You can also use your tax free lump sum drawdown from your pension - but then you need to put it somewhere while you are living off it, unless you have a requirement such as a mortgage to pay off, and not everyone will. So then you start to run into problems of earning savings interest income and going over your tax threshold again. So be careful of this.

EIS schemes may form part of your approach too - though from experience, you tend to gain on the tax side, while the investments themselves usually underdeliver, so you are lucky to come out flat from these trades. Not worth the effort in my view, but you could get lucky.

Once you have totted up how much taxable income you are getting, from occupational schemes, savings interest, annuities, and any pension drawdown you are making, and kept it below your higher rate tax threshold, which remains depressingly low at just over £50,000, what else can you do?

Well, you can monetize other investments, such as stocks and share portfolios. For this, you will be paying capital gains tax. The rules are complicated - read here for more. But even if you end up going over your tax threshold, you will pay no more than 24%, and it could be as little as 18% - helping to lower your effective tax rate on spendable funds (I won’t call it income, as this would be confusing) in retirement.

So, you’ve got your occupational pensions, a little rental income, some savings interest income and you’ve drawn down just enough of your SIPP to keep under the higher rate threshold (the 4% rule is basically irrelevent as you may not even be drawing this much to stay at a lower tax rate). You’ve maybe dabbled with any remaining allowances for further payments into the SIPP, or EIS schemes. You have supplemented these spendable funds with your ISAs, releasing a tax free income from them, and then you’ve really only got to decide how much extra to top this up from any other stocks and share investments you have at the appopriate, and hopefully lower 18% rate, taking advantage of your £3000 (mean!) tax free allowance.

Now it is worth asking if the 4% rule on this remaning investment drawdown makes sense. And again, it probably doesn’t. After all, it really depends on whether you intend to leave some, or none, of this to any dependents. If your goal is to maintain or even grow this pot, then you won’t be able to drawdown any more than the funds gain in a year - assuming they go up and not down. If you intend to leave none of it, or you have no dependents, then you can draw any amount, though it probably makes sense to do this at a rate that means the pot will slowly decline towards zero at your death - and unless you know with certianty when that will be, some caution may be warranted.

But just for an example - lets suppose I have an investment pot of £200,000. I believe I will live to about 80, and even if I make it past then, I am reconciled to a sightly less racy lifestyle from then on (fewer and less exotic holidays each year. More gruel, less caviar!).

Let’s suppose I put the entire pot into a broad globally and sectorally diversified set of stocks and shares funds. A not unreasonable assumption is that it will grow by about 7%. Some years it will fall, but some years it will grow by 15% or more. 7% is an average, and as we are looking at 20 years, that is long enough to weather any downturns so I’m not going to bother with bonds at all (if you want to spread some risk then by all means do so, and reduce the return accordingly, in any case, for a 60:40 split, you should stil pick up 5.5-6%).

At a 7% rate, even drawing down 4% a year, the pot grows from £200,000 to around £320000. The 4% drawdown also rises, from £8000 in year 1 to more than £13,300 in year 20, though that is worth approximately the same assuming an inflation rate of 2.5%.

But the case remains, do you want to leave all of this to dependents, who will be getting your house anyway, and any unspent SIPP of which there may be a large amount if you are trying to keep from going over your tax allowances as you draw it down?

What you decide to do must depend on your own circumstances. How long realistically do expect to live, and how lavish a lifestyle are you likely to have in your 80s and 90s? Do you have dependents? What are your intentions to them, and what will be the tax regime then?

In. short, a 4% rule is likely to be much to rigid for most people, and a much more fluid approach to this is probably warranted. Crack out your excel spreadsheet. Track your SIPPs and other pensions and investments, and work out how much you can monetize from these investments firstly based on how much tax you’d rather not pay. Then work out a sensible drawdown utilising non-income tax funds (Capital gains most likely) and estimate a sensible rate of drawdown taking into account likely fund growth (less if you take a more balanced approach, a bit more if you go full-on with equities). DO take account of inflation, always. It doesn’t have to be high to do real damage over the sort of timescales we are hopefully talking about. And it tends to overshoot, rather than undershoot. At least these days.

And have fun with it. There is frankly something liberating about not paying fees to IFAs who will simply bung your investments into a generic 60:40 fund which doesn’t always even deliver the protection intended (a lot of longer maturity bond funds are still underwater after the inflation and interest rate spike at the end of Covid). And in the end, the difference between an outperforming fund and an underperforming one may simply be the fees, which over time can deliver very large differences in investment values, and consequently, spending ability. Why pay for such lame financial service when you can do much better yourself?