That might seem obvious, but it opens up a whole raft of issues. Until well into my career, I didn’t think much about what a pension was. I just assumed that I should simply follow the government’s and my employer’s guidelines; then I’d have a comfortable guaranteed income after retirement. In other words, I thought my pension would take care of itself. I’m not sure exactly when I first realised that this was only the case for some people, but not for all. But eventually I woke up to the fact that for many if not most of us, we’d need to take at least some personal responsibility for our own retirement finances.
Defined benefit pension
By the time I’d heard the term “defined benefit”, I already had two personal pension plans. I learned that some companies funded a pension plan on behalf of its employees, guaranteeing them a retirement income that was some proportion of their final salary. These were known as “defined benefit”. For all I knew, my own plans were just as good, maybe better. I’d heard that the better the market performed, the better my eventual income would be. Okay, there was no guarantee, but it might work out even better than defined benefit, right?
Defined contribution pension
I learned that what I had was a known as a “defined contribution” pension plan. That sounded okay. It was the contribution that was defined instead of the benefit. So what? At least something was defined! I was lucky enough to move to an employer who made quite generous contributions into my pension plan, as a proportion of my salary. But it made me realise that during the years I’d been working previously, my plans had received much lower contributions.
So I started worrying about whether I’d have enough retirement income. Would the current level of contributions make up for the previous low level? And was the current level even enough? Another thing I realised was that all my old pension plan investments were in with-profits funds. It was beginning to dawn on me that this might result in lower growth than if I invested more heavily in shares, unit trusts, etc. I realised that I’d get full tax relief on any additional contributions I might make. So I decided to pump as much money as I could afford into my pension plan. I also started getting more stockmarket exposure from my new investments.
It became clear to me that my financial post-retirement future was messy and uncertain. I couldn’t see any guaranteed income on the horizon, save the state pension. My assumption was that at retirement I’d use the accumulated value of my pension fund (less a tax-free lump sum) to buy a lifetime annuity. This would be guaranteed in a sense, but I had no way of knowing for sure at what level. If there were a market crash the day before I bought the annuity, then it would guarantee me a lower income.
So my concept of a pension became that of a guaranteed state pension plus an uncertain level of guaranteed income from an annuity. I never really considered any assets outside my pension plans as contributing to my retirement income. I also didn’t think much about alternatives to buying an annuity on retirement.
Saving is supposed to be a ‘good thing’. You need to save in order to afford things in the future. The government encouraged savings and investments outside of pension plans by introducing the TESSA, later replaced by the ISA. These allowed tax-free income and growth. Many people started realising that they could use ISAs to save for retirement, whilst retaining the ability to access funds in an emergency. It’s not quite having your cake and eating it, though. Although ISA withdrawals are tax-free, you don’t get tax-relief when you put money in. With a personal pension plan, on the other hand, you get tax-relief when you put money in, but pay income tax on withdrawals. There are three things that tend to give pension plans the edge over ISAs from a tax-efficiency point of view:
- 25% of your withdrawals are tax-free.
- Your income tax rate is likely to be lower in retirement than while earning.
- Anything left in your pension plan when you die is not subject to inheritance tax.
But over-funding your pension plan can result in a tax charge, due to the Lifetime Allowance (LTA). This is not necessarily a disaster, and might just mean that your investments have grown faster than expected. But you need to take it into account when planning contributions, as it might negate some of the tax advantages. Any earned income not put into a pension plan and not spent or kept in cash, you should ideally invest in an ISA up to the maximum permitted.
At retirement, the value of any ISAs and other investments and savings all form part of your retirement fund. You can use it to generate income, just like a pension plan. For example you can also use it to buy an annuity. But you can also dip into it to top up any income from pension plans.
Before the government introduced Pension Freedoms in 2015, you had limited choices other than buying an annuity with your pension funds. There was such a thing as pension drawdown, whereby you sell and withdraw assets gradually from your plan. But it was tightly controlled and the withdrawal amounts were limited. And most people eventually had to buy an annuity anyway after a few years. Pension Freedoms changed all that. Annuities became completely optional. And there were no limits to the rate of withdrawal. Drawdown is now a major option for all retirees who’ve built up a pension fund.
In fact the only important difference between drawing down from a pension plan or from an ISA is in the way it’s taxed (or not taxed in the case of an ISA). All assets, wherever held, can be used for drawdown purposes, using taxation as the guide in choosing between them.
But how much should you draw down? In the ‘good old days’, when you expected to retire with a defined benefit pension, you could simply budget your spending based on your guaranteed retirement income. In fact you could budget well ahead of retirement, since your pension was based on your salary. But with pension drawdown, you need to estimate a safe withdrawal rate that won’t risk you running out of funds. Rules of thumb such as the 4% rule have been created to help, but they’re not very reliable. And when your retirement fund consists of a mixture of pension funds, ISAs and other investments, it becomes even harder to get it right.
Leave your pension plan till last?
Earlier I mentioned the tax advantages of pension plans. If you’re fortunate, you’ll have a retirement fund consisting of a mixture of pension and non-pension assets. Some advisers advocate not touching your pension at all until you’ve drained your other liquid assets (e.g. ISAs). The rationale is that this reduces your taxable estate, thus minimising eventual inheritance tax.
But inheritance tax is not the only tax consideration. You won’t pay any tax on ISA withdrawals. Sounds perfect? Well, yes, while it lasts. But once you’ve drained your ISAs (and other liquid assets), you’ll need to draw larger amounts from your pension than if you’d started earlier. This might push you into a higher tax bracket. Another consideration is that if you have quite a large pension pot, leaving it invested longer could increase the risk of breaching your Lifetime Allowance. Breaching the LTA is not necessarily a disaster, but it should be a consideration.
Then there’s the decision as to whether to draw your tax-free lump sum all in one go, or gradually via phased drawdown. There’s no one-size-fits-all answer to that question; it depends on personal circumstances.
If you knew exactly how your investments would grow, and exactly how long you’d live, it would in theory be possible to calculate precise rules to optimise tax. But of course you can’t know these things, so tax planning is necessarily uncertain.
Focus on outcomes
Our intelligent retirement calculator includes all your assets in your retirement fund: at least potentially. Some people don’t like the idea of including the equity of their home, because they want to leave it as a legacy. If you tell EvolveMyRetirement that leaving a legacy is important to you, it should optimise your plan so that it’s less likely you’ll need equity release; it will also be more likely to make fewer pension withdrawals in order to reduce inheritance tax. If leaving a legacy is completely unimportant to you, then these considerations wouldn’t apply.
In the end it’s outcomes that matter, not any one particular thing such as tax. Intuition can often lead us in the wrong direction. I used to be too focused on minimising my income tax bill, because I didn’t have the tools available to do a more holistic analysis. It was realising this that set me on the path to creating EvolveMyRetirement. At what level should I set my pension contributions? What amount should I draw out each year of retirement? How much can I afford to safely and sustainably spend? These were the questions I and so many others wanted answered. At last we have a tool that can help with these answers.