Retirement: what are the options, key considerations, how much you need to save and when you can retire - the whole shooting match.
For some people, their dream is not so much being able to afford retirement, it’s the aspiration of financial freedom - being able to work because they want to, rather than because they have to. Here, I'm going to examine the key considerations, what options there are, how much you need to save, how to save, and when you can look forward to retirement/financial freedom.
A recent report from the World Economic Forum predicted that the retirement age across much of the developed world would rise to 70 by the year 2050. It also suggested that the retirement age might rise to 80, at some point. But it may be underestimating things. Technologies such as CRISPR - clustered regularly interspaced short palindromic repeats – and linked with that Cas9, offer the possibility of editing DNA.
It is hard to be sure what the implications of such technologies are: but greater longevity seems highly likely. Whether that means people living to 100, 110, 120 or even older, becoming the norm, is uncertain. But there is a real possibility that many people won’t be retiring until they are 80 by the mid-point of this century.
That means people who are currently 48, may still have 32 years or more work to look forward to. That may seem depressing, but maybe it is better than the alternative - retiring old, but living long, using technology to enjoy good health, or retiring at 65, but keeling over a few years later.
But maybe it would be better to have both - longevity and many years of financial freedom to enjoy it.
So, what are the options?
Traditionally, when people retire, they convert their pension into an annuity - maybe after taking out 25 per cent, which they can do, tax free. The trouble is, annuity rates are currently lousy. A sixty-year old single person with £100,000 and who takes out an annuity would receive an annual income of around £5,000. If they have a partner and want the annuity such that one partner carries on enjoying an income after the other one dies, then that income reduces dramatically.
The big problem with annuities though - aside from the awful return - is inflation. If inflation is at two per cent, the rate the Bank of England is meant to target, then that means the real income from an annuity declines by two per cent a year. If inflation rises, then the decline is greater. You can reduce your risk, but at a massive cost. A sixty-year old single person, seeking a guarantee that income will rise with inflation, could expect an income from a £100,000 annuity of around £2,600.
One alternative to an annuity is to set up an ISA. This has two key advantages. Firstly, any income is free of further UK income tax. Secondly, if you hold the ISA in stocks and shares, on average, and over the long term, your income rises with inflation. Bear in mind that if you were to invest your ISA such that it tracks the FTSE 100, the yield on the portfolio should be around 3.8 per cent.
Of course, yield is not the only benefit from holding shares, you can get capital growth too, which is held within the tax efficient wrapper of the ISA. Even after allowing for inflation, over time, the growth in capital value, plus yield is typically similar to the current income from an annuity, but which is not index linked.
So far, then, an ISA seems more appealing than buying an annuity. But it comes with two downsides. For one thing, you can only invest £20,000 a year into an ISA. So, if you were to take your pension pot, and start channeling it into an ISA, it might take several years before you are fully invested.
For this reason, if you are looking at converting your pension pot into an ISA, it might be better to start building up an ISA portfolio before your retirement.
But investing in stocks and shares comes with another downside - volatility. History tells us that over time, stocks and shares tend to rise in value faster than inflation, with yield rising with inflation. But it is not like that every year. Some years, shares fall in value. Some shares do well, others collapse. That is why there are two key things you must do when investing in shares - have appropriate diversification and have a long-term investment horizon. Any retirement plan that relies on income from shares held in an ISA really needs an element of cash/bonds, to tide you over in years when markets perform poorly.
One option, if you can afford it, is to buy an annuity with 75 per cent of your pension pot, and use the 25 per cent tax free component to set up a stocks and shares ISA. That way, you may have the best of both worlds. Or you could go for options in-between, say 50 per cent annuity, 50 per cent ISA.
Pension versus ISA or LISA
Setting aside what to do when you retire - whether you should buy an annuity or buy shares - ideally via an ISA, securing tax advantages or an annuity - what should you do in the years - maybe decades - before retirement?
We can learn a lesson from Dr Carlisle Cullen, the fictitious vampire from the Twilight vampire series. The good vampire doctor is estimated to have amassed a fortune of around $34 billion dollars, making him the wealthiest man in fiction – finds Forbes. But there is no magic formulae that made him so rich. True, he started with a tidy sum, and made some shrewd investments, but the secret to Dr Cullen’s wealth is longevity and compound interest.
Vampires may not be real, but we are becoming more like them in one respect – we are living longer. As such we can emulate Dr Carlisle Cullen’s wealth building strategy and look forward to financial independence ahead of the time envisaged by many analysts. And in the process, protect ourselves from the danger of future redundancy – which may force early retirement upon us.
What can you do?
We have several options: some of course try to prepare for retirement by setting up a business - putting everything they have into that. Others set up a buy-to-let pension portfolio.
But two other options, which probably need to be considered even when you own a business or property portfolio, relate to building up savings either via a pension or an ISA/ Lifetime ISA, or both.
Lifetime ISA (LISA) and ISA
Both Lifetime ISA's (LISA) and as ISA's are tax-efficient wrappers, therefore no further tax is payable on the dividends or capital growth.
A LISA has both benefits and disadvantages compared with an ISA. Up to £4,000 pr year can be subscribed to a Lifetime ISA, which could be eligible for a 25% government bonus. However there are restrictions. If the money is withdrawn before the age of 60, unless it is for an auhorised withdrawal such as your first house purchase, it will be subject to a 25% penalty charge. In all likelihood you would receive back less than you paid in.
Do remember the £4,000 overall subscription is part of your overall ISA allowance.
With an ISA, the money saved is not topped up by the government, but the annual limit for saving into an ISA is £20,000, and a saver can withdraw from an ISA at any time.
A Self-invested personal pension – SIPP – offers similar benefits to a LISA, but the tax benefits occur at different stages. An individual who invests into a SIPP can, just as is the case with a LISA, receive tax relief on annual investments, but there are several key differences.
An individual who pays tax at a rate above the basic rate can enjoy a higher level of tax relief, and tax relief can apply to a much higher level of annual contribution – £40,000. Once cashed in, assuming the pension holder is over 55, 25 per cent of the proceeds from the pension are free of tax. Income from the remainder of a pension is subject to tax.
Start saving as soon as you can
Savings compound. Money invested in shares can compound much faster. If you are able to save £4,000 a year and invest into a LISA, then with the government bonus, that’s £5,000 a year. Start saving at that rate when you are 30, then assuming an average five per cent return (after inflation, including capital growth and income re-invested), within 15 years, the portfolio would be worth £100,00, within 24 years, £200,000 and within 30 years £300,000. The income on £300,000 would not buy you the life-style of Rockefeller, but it would give you a tax-free income that would at least move you closer to financial freedom.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees