Sobering retirement income drawdown demonstrations – 12.5 years in

Another year has passed for our UK early retiree.  A year ago I wrote that in the worlds biggest economy, the United States, Donald Trump was starting trade wars and the S&P500 cyclically adjusted price earnings (CAPE) ratio was sitting at 32.0 against a long run average of 16.9.  A year on it’s almost déjà vu with the trade war with China still rumbling along and the S&P500 still on a high 30.4.  Closer to home I wrote that we had a Brexit shambles playing out in slow motion that might just ruin the economy for a long time.  A year on and the whole Brexit situation has moved on to become a joke with politicians continuing to promise unicorns while the FTSE100 has fallen 2.8% in nominal terms.  Of course dividends continued to be paid which will have dampened that fall.

Against this environment it’s unlikely a UK early retiree who has opted for a higher withdrawal rate will be dancing for joy but let’s take a look.

This update of the drawdown demonstrations now has our retiree some 12.5 years in to retirement.  It assumes our retiree is not one of the lucky ones sitting on a defined benefit pension (although it’s likely they’d need some other income source in the early years if they’re going to FIRE), isn’t intending to buy an annuity (again, not likely for the early years of FIRE) and isn’t planning on living off the State Pension (although 12.5 years in to retirement our UK retiree might just be starting to get to an age where there might be some predictability in what they might receive here so they might want to start baking a portion into their models).

We are now fast approaching the half way mark that the 4% rule is based upon and this simulation assumes retirement was taken on the 31 December 2006.  If this date sounds convenient then you’re right.  The date was deliberately chosen as it is the year prior to the commencement of the global financial crisis and so hopefully represents a modern worst case.  Someday it may even go down in history as one of the time periods which saw a poor sequence of returns however of course that will only become clear when we are firmly looking in the rear view mirror many years hence.

Sobering retirement income drawdown demonstrations – 11.5 years in

As I write this post the S&P500 cyclically adjusted price earnings ratio sits at 32.0 against a long run average of 16.9, Donald Trump is starting trade wars, the US market has been in a bull cycle for well over 9 years and closer to home we have a Brexit shambles playing out in slow motion that might just ruin the economy for a long time.  Then on a personal front I’m just about to ride off into the FIRE sunset.

S&P500 cyclically adjusted price earnings ratio, click to enlarge

Against this backdrop it feels right to reinvigorate and update the UK retirement income drawdown series, which I last posted about 2 years ago, to see how things are playing out.  I hope it’s not relevant to my situation but you just never know.

Unless you’re one of the lucky ones sitting on a defined benefit pension (although it’s likely you’ll also need some other income source in the early years if you’re going to FIRE) or you intend to buy an annuity (again, not likely for the early years of FIRE) or you’re just planning on living off the State Pension then income drawdown in FIRE (or even just plain old retirement) is relevant.

This update of the drawdown demonstrations now has our retiree some 11.5 years in to retirement.  We are now just over one third of the way through the period that the 4% rule is based upon and this simulation assumes retirement was taken on the 31 December 2006.  If this date sounds convenient then you’re right.  The date was deliberately chosen as it is the year prior to the commencement of the global financial crisis and so hopefully represents a modern worst case.  Someday it may even go down in history as one of the time periods which saw a poor sequence of returns however of course that will only become clear when we are firmly looking in the rear view mirror many years hence.

Another pension partial transfer and the elephant in the room

By now it’s no secret that I dislike investment expenses and continually work to minimise them in the most cost effective manner.  I’ve also written previously about how my work defined contribution (DC) pension scheme gives no special benefits but does extract at least 0.6% in annual expenses.  I’ve also previously written about how I take advantage of the pension partial transfer rules by transferring to either of my SIPP providers when they have some sort of special offer and I have a sensible amount of funds in my work DC pension.

Well Hargreaves Lansdown currently have a cash back offer running:

Click to enlarge, Cash back of between £20 and £500 available

I also had a little over £10,000 in my work DC pension so again the used Hargreaves Lansdown electronic transfer service.  It was another good experience with the online form being completed during last week’s bank holiday, Hargreaves Lansdown acknowledging my instructions on the Tuesday and the transfer being complete by the Friday.  The end result:

• Partial transfer completed in 4 days;
• Expenses reduced from 0.6% to between 0.07% and 0.19%.  I bought Vanguard ETF’s and that is their annual expenses.  On the Hargreaves Lansdown side, other than purchase costs, there are no extra expenses because I only buy shares/ETF’s in this SIPP and already have more than £44,444 which means my expenses are capped at £200;
• £20 will soon appear in my SIPP. 

Holding pattern musings

2017 so far is starting to feel like I’m in a bit of a holding pattern.  We’re starting to feel excited about the new adventures we are going to face in FIRE, I feel like a small part of me has already left my workplace yet I don’t want to go any further until my 2016 bonus is paid and a longer term incentive also appears.  Not long now.

While in that holding pattern I’ve just continued with my saving hard and investing wisely strategy which has my wealth this year already up £36,000 to £1,155,000.  More than enough to live the lives we want to live in FIRE.  There’s also been a few events and learnings over the period.  Let’s look at a few in brief.

Budget

Philip Hammond delivered his Spring Budget statement, which for people like myself, was just another chance to increase taxes.  Previously, from 06 April 2016 the dividend tax credit was abolished and a new tax free £5,000 dividend allowance was introduced to partially compensate.  Hammond has decided he wants some of that so from the 06 April 2018 will reduce the allowance to £2,000 ‘to address unfairness’.  Dividends above this level will be taxed at 7.5% if you’re on the basic rate, 32.5% if you’re on the higher rate and 38.1% if you’re on the additional rate.

If I stayed in my current grafting up state Hammond would have grabbed another £1,143 from my pocket.  But alas times are a changing.  We’ll be in the Med by late summer with that more and more looking like being Cyprus.  There I’ll use the Cyprus and UK Double Taxation Convention, the Cyprus non-domicile rules and the Cyprus tax laws to pay precisely £0 in tax.  Sorry Mr Hammond not on my watch...

Pushing pensions to the limit

I continue to find pension wrappers are a powerful tool for building FIRE wealth quickly.  Let me demonstrate with a couple of quick examples:

• Over my FIRE journey I am fortunate to have found ways to earn more which means that I am today a 45% additional rate tax payer.  On top of that I also have to pay 2% employee national insurance on the last of my earnings.  This means that if I earn £10 and I don’t salary sacrifice it into a pension wrapper I only end up with £5.30 to invest.
• My employer allows pension salary sacrifice, has a contribution match up to a certain percentage and also gives me 10% of the 13.8% employer National Insurance that they save when I contribute to the company pension.  So under these conditions if I put that same £10 into the company pension I actually end up with £21 to invest.  That’s nearly 4 times more.
• Even if I continue to contribute to the pension wrapper once the employer match is over its still favourable.  In that instance I still end up with £11 going into the pension which is more than 2 times the savings outside of the pension.

The wise among you will now being saying ‘but pensions are just a tax deferral scheme’ and that’s certainly true but let’s look at how that will play out in FIRE.  The UK in my view can almost be considered a tax haven for those with enough wealth that work is not required.  To demonstrate let’s take £20,000 from that pension pot every year.  The 25% pension tax free lump sum effectively gives one £5,000 tax free.  Then one also gets a 0% tax rate from the £11,000 Personal Allowance leaving just £4,000 subject to 20% Basic Rate tax.  That works out to be an effective rate of tax on the £20,000 of just 4.0%.

Move to the Mediterranean and it could be even more favourable.  Cyprus, for example, gives a choice of how pensions can be taxed.  The first is 0% tax until you earn EUR19,500 with the next band being 20%.  In this example our £20,000 (assumed to be EUR22,460) sees an effective tax rate of just 2.6%!  The other method favours high pension sums as the income is taxed at the flat rate of 5% on amounts over EUR3,420.  In this example one’s effective tax rate would be 4.2% so one would pick the former in this example.

Rearranging my YouInvest SIPP

I have had a YouInvest (formerly Sippdeal) SIPP (Self Invested Personal Pension) wrapper since 2011.  It came about when I first started transferring expensive insurance company based Stakeholder and Group Personal Pensions across to SIPP’s to save on expenses.  Over the years this SIPP has grown steadily to become a significant portion of my wealth as it now contains circa £200,000.

Within the YouInvest SIPP I was holding the following three investment products:

• The Vanguard FTSE U.K. All Share Index Unit Trust with annual expenses of 0.08%;
• The Vanguard U.K. Inflation-Linked Gilt Index Fund with annual expenses of 0.15%; and
• The iShares European Property Yield UCITS (IPRP) with annual expenses of 0.4%.

For the privilege of using the YouInvest SIPP wrapper I was also paying annual expenses of £300 which was coming in the form of:

• A YouInvest SIPP custody charge of £25 per quarter as my SIPP value was greater than £20,000; and
• A YouInvest Funds (Unit trusts and OEICs) charge of 0.2% per annum but which was capped at a maximum of £50 per quarter

Life was good and even though I didn’t like paying the £300 per annum I didn’t do anything about it as to correct it I would have had to be out of the market and might lose significantly more than I gained.  That was until I received a notification from YouInvest in early August 2016 that they were intending to change their charging structure from the 01 October 2016 which included a great reason [sic] for the change – “We believe this will be easier to understand, whilst maintaining AJ Bell’s commitment to offering some of the lowest charges in the market.”

The power of AND

Putting the scores on the doors reveals that I progressed to my Financial Independence number at a rate greater than 0.9% per month.  In hindsight this wasn’t because of any one particular silver bullet but instead was made possible by focusing on the personal finance many, rather than a few, or even the one talked about so often, investment return.  Putting it another way I focused on the personal finance AND.  Mechanically that included earning more and spending less and an appropriate portfolio and minimising taxes and minimising expenses and investment return.  Psychologically that included starting and determination and accepting I’ll make mistakes and never becoming a victim to name a few.

Over the last couple of weeks I think I’ve shown this trait again by maximising pension contributions while also minimising expenses.

I have two low cost SIPP’s (two rather than one is for risk minimisation reasons) in which I buy low cost tracker products.  This is my method of minimising pension wrapper expenses and investment product expenses.  However, even though I have these and they would enable me to defer tax if I invested in them directly I choose not to use this route.  Instead all my contributions enter pension wrappers via my employer’s expensive defined contribution old school insurance company group personal pension.  I do it this way as in addition to deferring tax like I could also do in the SIPP this maximises my contributions in a few more ways:

• My company does an employer match up to a few percent, which of course I take advantage of, however I also contribute a lot more than this for the two reasons below;
• My company allows salary sacrifice which means I get an extra 2% contribution into my pension rather than it being lost to employee national insurance contributions;
• My company adds 10% of the 13.8% employer national insurance contributions that they save if I sacrifice into the pension. 

So I’ve maximised contributions but my employer’s pension scheme then has the big elephant in the room - Expenses.  I try and keep it to a minimum by buying into their tracker funds but even this means I’m paying annual expenses of between 0.6% and 0.87% depending on fund selected.  I can do much better than that in my SIPP’s.  So the trick is to complete a partial transfer into my SIPP when the pot becomes a reasonable size.  The last time I did this it could only be described as a palaver however this time the more appropriate description would be a doddle.

Sobering retirement income drawdown demonstrations – 9.5 years in

Unless you’re one of the lucky ones sitting on a defined benefit pension (although it’s likely you’ll also need some other income source in the early years if you’re going to FIRE) or you intend to buy an annuity (again, not likely for the early years of FIRE) or you’re just planning on living off the State Pension then income drawdown in FIRE (or even just plain old retirement) is relevant.

This is the annual update of a series of drawdown demonstrations that are now some 9.5 years in.  To put this in perspective we are now within a whisker of one third of the way through the period that the 4% rule is based upon and this simulation assumes retirement was taken on the 31 December 2006.  If this date sounds convenient then you’re right.  The date was deliberately chosen as it is the year prior to the commencement of the global financial crisis and so hopefully represents a modern worst case.  Someday it may even go down in history as one of the time periods which saw a poor sequence of returns however of course that will only become clear when we are firmly looking in the rear view mirror many years hence.

Over the years readers have suggested various alternatives for these demonstration portfolios however for long term consistency I want to make as few changes to the original assumptions as possible so will stick with them for now.

Where we left our retiree’s last year can be found here.  In brief, the key assumptions are:

• Our retiree’s are drawing down at the stated withdrawal rate plus fund expenses only.  This means any trading commissions, wrapper fees (eg ISA, SIPP fees), buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% initial withdrawal rate retiree is actually drawing down at between 2.1% and 2.2% dependent on the asset allocation selected.  
• 6 Simple UK equity / UK bond portfolios are simulated for our retiree.  The UK equities portion is always the FTSE 100 where the iShares FTSE 100 ETF (ISF) is used as the proxy.  This fund currently carries expenses of 0.07% however this has been as high as 0.4% in the past.  For the bonds portion a simulation is run against UK gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I have preferred in my own portfolio, UK index linked gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• All calculations are in real (RPI inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree’s to have £600,000 just multiply all the subsequent pound values by 6.

A 4% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 4% Withdrawal Rate, 30 June Value, Click to enlarge

I always start with a 4% withdrawal rate because of the often quoted 4% safe withdrawal rate rule.  The 50% equity : 50% gilts portfolios (the red lines on the chart) are the closest representations to the 4% rule with obvious differences being that:

• the 4% rule was for a US based investor with US based investments while I’m simulating UK investors with UK based investments; and
• the 4% rule doesn’t consider fees where I’m capturing the OCF’s of the ETF’s which makes my withdrawal rate very slightly higher.

Another pension’s consultation begins just as the last consultation ends

There were plenty of articles in the mainstream media this week musing about the potential changes that were coming to private pension’s in this month’s budget.  Would Osborne introduce a pension’s ISA, would he introduce flat relief on pension contributions, would he abolish salary sacrifice or would he just cut allowances?  As is so often the case with budget’s these days it looks like we don’t have to wait until budget day for the answer.  Osborne has apparently decided that “There won’t be any changes to tax relief at all in the Budget” (free FT link or Google Osborne scraps pension tax relief shake-up).  So it looks like for now I can just continue with Plan A which predicted no pension tax changes for ‘high earners’ in the 2016/17 tax year.

While all these articles were getting attention it was actually this article (free FT link or Google State pension review begins with John Cridland as head) that has had me more concerned.  This was the announcement that another review of state pension ages has kicked off, from which recommendations will be made in May 2017.  ‘Experts’ are predicting that millennials joining the workforce today might be waiting until their mid-70’s before they can retire.

Now for me it’s not the potential state pension age change itself that worries me, as all my FIRE (financially independent retired early) planning never includes the state pension.  This is because I never wanted to be held to retirement age gun-point by our ever tinkering government with any state pension I might (I actually believe I may never receive any as for example it will end up means tested) receive being an insurance policy only.

Navigating the Never Ending Changes to Pensions

In recent years it feels like every Spending Review, Autumn Statement and Budget presented by our wonderful government includes pensions tinkering which is usually detrimental to what I and many others are trying to achieve.  I'm now at the point where prudence means I have to run some simulations to ensure I don’t fall foul of some new rule or other.  This has forced me to do some research and so in the spirit of sharing here goes.

Wealth warning.  I am not a pensions expert nor a financial planner.  I've also made investment mistakes in the past and will certainly make them in the future.  I also don’t know every pension rule and regulation out there.  I dread to think how long it would take someone to learn all of those.  Therefore this is not a recommendation of any type but instead hopefully provides some terms and tit bits that you the reader may not be aware of which will then encourage you to do some research like I have been.

At their heart defined contribution pensions are nothing more than a tax deferral scheme.  The deal is that you agree to lock up your money for the future and agree to follow the (continually changing) terms and conditions.  In exchange the government (currently) allows you to not pay tax on it now but rather when you unlock it in the future.  I agree to participate as for me it has the potential to be quite beneficial to wealth building as my current effective tax rate is now 47% (45% additional rate + 2% national insurance) and in the future that tax rate could be:

• 0% and maybe a bit of 20% if we stay in the UK.  On top of that current rules will allow 25% to be taken as a tax free lump sum (TFLS);
• 0%, 15% and 25% if we head to Malta; or
• 0%, 19.5% and 21.5% if we head to Spain

That is a big enough incentive for me to use pensions as part of my overall investment strategy.  To maximise the benefit I want to get as much into my pension wrapper as possible while ensuring I keep enough outside of the wrapper to cover all costs and government tinkering between early retirement and my private pension access age which is currently age 55.  I think the first is an easier thing to calculate than the second given current government form.

A Sobering Income Drawdown Demonstration – 8.5 Years In

While my recent posts on sequence of returns risk during drawdown and bond to equity volatility vs returns are still fresh in our minds let’s return to our retiree's who are another drawdown year on having now been in wealth drawdown for 8.5 years.

For long term consistency I want to make as few changes to the original assumptions as possible however this year one change would seem prudent.  To represent the equities portion of the portfolios I use the iShares FTSE 100 UCITS ETF (ticker: ISF) as a proxy.  This year that ETF has become an iShares Core Series ETF resulting in a TER change from 0.4% to 0.07%.  I'm going to allow that change to occur within the assumptions as it simulates a real change that an investor might see.  All other assumptions are unchanged from the original post.  Re-emphasising some of the key assumptions:

• Our retiree’s are drawing down at the stated withdrawal rate plus fund expenses only.  This means any trading commissions, wrapper fees (eg ISA, SIPP fees), buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% initial withdrawal rate retiree's are actually drawing down at between 2.10% and 2.21% dependent on the asset allocation selected.
• All calculations are in real (inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• 6 Simple UK equity / UK bond portfolios are simulated for our retiree's.  The UK equities portion is always the FTSE 100 where as mentioned above the iShares FTSE 100 ETF (ISF) is used as the proxy.  For the bonds portion a simulation is run against UK gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I prefer in my own portfolio, UK index linked gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree’s to have £600,000 just multiply all the subsequent pound values by 6.

A 4% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 4% Withdrawal Rate, 30 June Value, Click to Enlarge

I've picked a 4% withdrawal rate because of the often quoted (dangerously in some cases IMHO but that’s for another day) 4% safe withdrawal rate rule.  The 50% equity : 50% gilts portfolios (the red lines on the chart) are the closest representations to the 4% rule with obvious differences being that:

• the 4% rule was for a US punter with US based investments while I'm simulating UK punters with UK based investments; and
• the 4% rule doesn't consider fees where I'm capturing the OCF's of the ETF's which makes my withdrawal rate very slightly higher.

My Investment Portfolio Warts and All

Two events have occurred in the past week that prompt this post:

1. My Defined Contribution Company Pension transfer to a Hargreaves Lansdown SIPP has now completed.  The timings ended up being that I sent all the paperwork to Hargreaves Lansdown on the 09 May ’15, received a confirmation letter that it was in progress on the 13 May, the cash landed in my new Hargreaves Lansdown SIPP on the 29 May, I bought all my new low expense investment products (which made this post a little redundant) on the 01 June and the £500 cash back offer landed in my account on the 05 June.  So all in about a month for it all to wash through.  Total Investment Portfolio expenses including SIPP wrapper charges now run to 0.28% per annum.
2. I received a Facebook message from a reader asking if I could do a post with “a really detailed breakdown of my portfolio starting with a rough pie chart with just equities, bond, gold, alternative investments, property etc and then a more detailed breakdown again perhaps an exploded pie chart of the main parts. For example share category American, European shares etc.”  When I read the message I realised that while I've talked ad infinitum about my portfolio over the years I've never given such a detailed breakdown including investment product percentages.

So without further ado here’s my investment portfolio warts and all.

The investment strategy (some might call it an Investment Policy Statement) on which my portfolio is based has now been in place almost since the beginning of my journey.  I first documented it in 2009 but I would suggest reading my 2012 strategy summary (as it included the addition of my High Yield Portfolio (HYP) for a portion of my UK Equities) in parallel to today’s post.  The strategy post will give you the “Why” behind my thinking while today’s post will give you the “What”.  It’s also important to note that nothing I do is original or clever.  It’s predominantly based on work by Tim Hale which is a book that I believe every UK investor should read with tweaks coming from the reading of the following books.

The Top Level Investment Portfolio

Click to enlarge, My Actual Low Charge Investment Portfolio

At a top level the portfolio contains local and International Equities, Commodities, Property, Bonds and Cash.

Insuring Against Sequence of Returns Risk with the State Pension

Anybody who is intending to retire (particularly those taking early retirement) without a healthy Defined Benefit Pension or without knowledge of a guaranteed healthy inheritance should be wary of and maybe even have a healthy fear of sequence of returns risk.  It is the risk of receiving a series of investment returns that are negative (or lower) during a period when you are in portfolio/wealth drawdown which then never allows your wealth to recover even when investment returns normalise.

Blackrock have a couple of charts which demonstrate the phenomena nicely.  Firstly, let’s look at Sequence of Returns during the Wealth Accrual Phase (ie before Retirement).  The chart below shows 3 investors who each make an initial investment of $1,000,000 at age 40 and then never invest again.  Each has an average annual return of 7% but each experiences a different sequence of returns.  25 years later each has the same portfolio value even though valuations varied along the way.

Click to enlarge, Sequence of Returns during Wealth Accrual Phase

Now let’s look at Sequence of Returns during the Wealth Drawdown phase.  Again we have our 3 investors making the same initial $1,000,000 investment, the same average annual return of 7% with annual returns following the same sequences as during the Wealth Accrual Phase.  25 years later each have very different portfolio values with Mr White now forced to beg for food under a bridge.

Transferring my Company Pension into a SIPP – Part 2

On Saturday the SIPP of choice for my Company Pension transfer was heading towards Interactive Investor and their annual costs of £176.  Valued reader comments plus some more DYOR has instead led me to Hargreaves Lansdown.  Before you Comment that they are an expensive percentage fee broker/platform with annual charges of 0.45% let’s run through my thinking.

Firstly, dearieme highlighted that provided you stick with Shares, investment trusts, ETFs,
gilts & bonds and don’t add any funds Hargreaves Lansdown become a percentage fee broker/platform but with a capped maximum annual expense of £200.  I can work within that no fund criteria.  So now once your pension is greater than £44,444 that 0.45% starts to reduce.  Transfer £100,000 and it’s down to 0.2%.  On top of that John and Cerridwen also raised some red flags against Interactive Investor.

Secondly, even though the SIPP is now capped I hear you saying that it’s still £24 a year more expensive than Interactive Investor and sweating the small stuff matters.  This is where it gets interesting.  Hargreaves Lansdown currently have a promotion running until the 12 May 2015 that provides a cash back incentive for transfers of Stocks & Shares ISA’s, Cash ISA’s, Junior ISAs/Child Trust Funds (CTFs), Funds, Shares and Pensions.  They also advise that “if you need more time to decide please let us know and we will extend this deadline for you (up to three months for ISA, fund and share transfers, and six months for pensions).”  Transfer big sums and it’s a significant amount.  Between £100,000 and £124,999 and its £250 cash back which means you’re now ahead of Interactive Investor’s current annual charges for 10 years.  Transfer £125,000 or more and its £500 which puts you ahead for 20 years.  Dealing costs for me are going to also be £1.95 more expensive than Interactive Investor but I think I can set the SIPP up with 9 trades which would take a bit under 1 year off that benefit.

I highlighted in Saturday’s post that the reason for not just using my current YouInvest SIPP was the all eggs in one basket risk.  I currently have some of my HYP in a Hargreaves Lansdown Vantage Fund & Share Account and so adding a Hargreaves Lansdown SIPP will increase my exposure with this provider from 6% to 21%.  I’m ok with that level of risk.

So by switching from Interactive Investor to Hargreaves Lansdown I can save some money while also moving to a wrapper that I know and am happy with while keeping provider risk to acceptable levels.

Transferring my Company Pension into a SIPP

About half of my current monthly savings are salary sacrificed into my employers Defined Contribution Pension plan.  I do this over adding directly to my own personal SIPP for a few reasons:

• My employer matches contributions up to a certain level;
• My employer adds the majority of the employers National Insurance that they save into the pension; and
• The 2% employee National Insurance that I would have paid is also able to be added into the pension

Wealth Warning: Before I proceed it’s worth reinforcing that my employer pension plan is a Defined Contribution Pension and not a Defined Benefit Pension.  It also provides absolutely zero additional benefits.  If it was or did either of those things what I describe below may not be the right approach.

These benefits definitely outweigh the high 0.6% to 0.76% expenses I'm then paying for trackers and the lowest cost active funds (where a tracker is not available) within the Pension.  That said if I could find a way to get the money in through salary sacrifice as I do today but then transfer at regular intervals into my SIPP I’d get all the salary sacrifice benefits of the company pension as well as all the low cost benefits of a DIY SIPP.  This effect would be noticeable as I've been with my current employer for a large portion of my Financial Independence Retire Early (FIRE) journey meaning some 15% of my total wealth is now held within the company pension.  I estimate it would reduce my total wealth annual expenses from 0.31% per annum to about 0.25%.  0.06% doesn't sound like much until you run the numbers and realise its £60 per annum if your wealth is £100,000 and £600 per annum on £1 million.

Regular readers will know I've been trying to find a way to do this for some time.  I've tried two different angles:

• Get my employer to open me a new Pension policy with them salary sacrificing into that new account.  The old account would then be dormant allowing a trivial SIPP transfer by simply filling out the short transfer form that is available from any SIPP provider.  Unfortunately my employer wouldn't budge here as it was just too much “admin”.
• Ascertain from the insurance company who provides the Defined Contribution pension if and how this can be done.  They obviously have a vested interest in being as slow and obstructive here as possible.

I am however pleased to announce that many emails, phone calls and a lot of time later I have achieved success.  In case any readers are trying to do something similar the form I needed is what is called a Declaration of Claim Discharge which is a simple 2 page form which importantly includes a section called a Partial Transfer Request which enables me to check a box entitled “If you wish to move the ‘maximum amount’, please tick the box opposite”.  All I have to do is complete this form and then attach it to the SIPP transfer form from my chosen SIPP provider and I'm away.

The Two Phases of Wealth Building

Every week I religiously capture the value of each of my investments which I then sum to give me an instantaneous net worth.  This week saw my net worth increase by more than £5,000 without contributing any new money.  For me that is a very large amount of money, and of course Mr Market could take that £5,000 away this week, but it reminded me of the two phases of wealth building that I'm seeing as I'm working to build wealth over a quite short period of time.

The first phase is Building Capital.  As you start on your wealth building journey this is the first phase you pass through.  Here you just want to be adding as much capital to your wealth as quickly as you can get your hands on it.  Saving Hard by Earning More and/or Spending Less will have a much bigger effect in this phase than Investing Wisely.

The second phase is Return on Capital.  Here while Building Capital is still providing a big boost to your wealth it’s now more important to have a stable investment strategy which is very tax and investment expense efficient.  In this phase you could even start to ease of the Saving Hard by for example going part time or taking up that lower paid higher enjoyment opportunity you’ve always desired without moving your financial independence day greatly.

Let me demonstrate the two phases with a simple example (where I’ll ignore inflation) that tries to cover many of the points that I personally live (and have lived) as well as regularly capture on this site.  Average Joe works hard and for his hard work receives £45,000 per year making him a 40% higher rate taxpayer.  Joe wants early financial independence to give the option of early retirement and so starts to think about he might achieve that.  He realises he firstly needs to focus on Building Capital by Saving Hard.  His employer offers a pension scheme where if Joe salary sacrifices 5% of his own salary then they will match it.  There’s some free money there so he goes for it.  Salary sacrificing also brings the benefit of lowering Joe’s taxable salary to £42,750 saving both employee and employer National Insurance.  Joe’s employee NI saved is added immediately to his pension but his employer also generously adds the 13.8% employer NI that they also save.

Freedom and Choice in UK Pensions : It’s Not All Good News for Responsible UK Personal Pension Holders

As part of the UK Budget 2014 George Osborne briefly announced the next tranche of government pension tinkering.  More detail in the form of the fifty page document entitled Freedom and choice in pensions : government response to the consultation has just been published so let’s briefly look at what I think is the good, the bad and the ugly as far as I'm concerned.

The Good

The Budget included the announcement that from April 2015 pension holders would get unrestricted access to their personal pension savings.  The mainstream media became all excited and started talking about people cashing in the lot and buying Lamborghini’s.  I ignored this nonsense and thought it actually might give responsible people (like myself?) who are saving for their future an intangible benefit so have been keenly waiting for the detail.

I currently have 44% of my wealth tied up in Pension Wrappers as they have the potential to (I say ‘have the potential to’ and not ‘will’ as once you’re in it’s difficult to get out again without punitive taxes and governments are guaranteed to continue to tinker) give me a healthy reduction in tax over my lifetime.  This comes from a few areas:

• As a Higher Rate taxpayer while working but expecting to be a Basic Rate taxpayer in retirement I’m avoiding 40% tax now in exchange for 20% tax as I start to withdraw from my pension.
• By salary sacrificing I’m also getting the employee national insurance that would have been paid on the sacrificed amount added into my pension as well as the majority of the 13.8% my employer saves by not having to pay employers national insurance on the scarified amount.
• Being able to take a 25% tax free lump sum at retirement. 

A Sobering Income Drawdown Demonstration One Year On

When we left our UK Invested Income Drawdown dependent Retiree’s a year ago there was trouble afoot.  Our 4% Withdrawal Rate Retiree, which remember is the Safe Withdrawal Rate (SWR) Rule of Thumb many talk about and even use, was particularly vulnerable having lost between 11% and 24% of wealth in only 6.5 years.  Since then a couple of notable things have occurred:

• The 2014 budget saw the income drawdown rules again altered.  From the 27 March 2014 retiree’s are now able to withdraw from their pensions at the rate of 150% of the Government Actuary’s Department Tables (GAD Tables).  Additionally flexible drawdown, allowing unlimited withdrawals from your pension pot, is now available for anybody with a guaranteed income of £12,000.  Then from April 2015 these rules will change again and allow unlimited access to our pensions from age 55.
• The second is that Professor Wade Pfau published research showing a UK retiree positioned with a 50% UK Equities/50% UK Bonds portfolio and drawing down using the 4% SWR rule of thumb would actually run out of wealth 23.8% of the time within a 30 year period.  Scary stuff given how loosely the 4% Rule is bandied around the personal finance blog world these days.  Professor Pfau then calculated that if history should repeat (and of course past performance is not necessarily indicative of future results) then to ensure you don’t run out of money over a 30 year period your withdrawal rate before investment expenses and taxes are deducted has to actually be less than 3.05%. 

Going forwards this is going to make life interesting.  For a retiree to draw down £24,856, the equivalent of current average UK earnings (Office for National Statistics KAB9 dataset), requires wealth (including Pensions, ISA’s and non-tax efficient investments) of £814,950 if we are to minimise depletion risk over 30 years according to Pfau’s research.  At the same time from next year we can grab whatever we like from a pension pot that on average only contains £36,800 at retirement according to the Association of British Insurers.  Of course many of us don’t just save in pensions (for example only 43% of my wealth is in a Pension of which only 14% is sitting with expensive inflexible insurance companies) and of course not all of us will withdraw crazy amounts to buy Lamborghinis (if the rules haven’t changed I’ll be withdrawing as much as possible to keep my total earnings just below the Higher Rate tax limit with the difference between spending and withdrawal being put into an ISA) but it’s probably uncontroversial to suggest it does have the potential to leave the uneducated very exposed.

With that in mind let’s look at how our UK Invested Income Drawdown dependent Retiree’s are doing one year on.  For consistency all assumptions are unchanged.  Re-emphasising some of these assumptions:

• Our Retiree’s are drawing down at the stated withdrawal rate plus investment expenses.  This means any trading commissions, wrapper fees, buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% Initial Withdrawal Rate Retiree is actually drawings down at between 2.25% and 2.36% dependent on the asset allocation selected.   
• All calculations are in real (inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• 6 Simple UK Equity / UK Bond Portfolio’s are simulated for our retiree.  The UK Equities portion is always the FTSE 100 where the iShares FTSE 100 ETF (ISF) is used as the proxy.  For the bonds portion a simulation is run against UK Gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I prefer in my own portfolio, UK Index Linked Gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree to have £600,000 just multiply all the subsequent pound values by 6.

Should I put my UK Pension into Income Drawdown or Buy an Annuity

As I sit here, as a late 40 year old, writing this post 41% of my wealth is held within pension wrappers including a very healthy SIPP.  If I stay the course with my Investment Strategy then Early Retirement will likely appear around age 44.  Running a forecast to that age, which looks at my intended contribution profile and expected portfolio diversification into both the pension and non-pension assets, would result in 44% of my wealth being within pensions at that point.  This is of course only going to be true if the my investments perform on average over that period which of course is a big if but is all I have to use for forecasting.

If I then continue with the Transition to Retirement Strategy which includes the purchase of a home for my family and includes rapid pay down of the mortgage in the 11 or so years until I can access my pension assets then my pension wealth will rise quickly as a percentage of total wealth.  This is because my non-pension assets will need to generate my salary as well as pay down the mortgage while the pension continues to grow in value from investment return.  To demonstrate the severity of this if I step my retirement forward 10 years to age 54 my pension wealth could be as high as 83% of my total wealth.  This excludes any equity which I will have in the family home which might frustrate The Investor over at the excellent Monevator somewhat.  That’s a lot of wealth tied up in a wrapper that has a track record of being tinkered with by government.  What’s also interesting is that as I leave the early retirement phase of my life and become a typical retiree my position is probably not that much different to most people who have saved in a pension for a typical retirement.

Step forward 1 year to 55 and it all gets interesting, at least under current pension rules, as I can now start to access my pensions.  The no brainer for me is that I’ll firstly take the 25% tax free lump which in line with the Transition to Retirement Strategy will be used to pay off the mortgage, maximise that years ISA contribution and invest the remainder as tax efficiently as possible.  At that point my forecast suggests around 75% of my total wealth is now within the pension.

Unless I’ve missed a trick I believe I now have essentially two options if I want to generate an income from the remaining pension pot.  I can put the pension into Income Drawdown or alternatively buy an Annuity.  Let’s look at the Pro’s and Con’s of each option plus run an example for each option based on my situation assuming I was 55 today.

Simplifying the Complex Pension Problem

 Ask anybody at a party or family gathering about personal Pensions, whether that be a now all to rare Defined Benefit Scheme or a Defined Contribution Scheme (such as a Stakeholder Pension, Group Personal Pension, the new National Employment Savings Trust or (NEST) Pension or the ultimate in DIY Pension Provision, a Self Invested Personal Pension (SIPP)) and it’s likely they’ll glaze over.  From my own experiences I feel this occurs for three main reasons – upbringing or culture, mistrust and lack of knowledge.  Let’s look at each of these in turn.

Upbringing or culture

The vast majority or people learn from a young age to spend and save what’s left.  That philosophy is then continually reinforced through a never ending bombardment of advertising which not only encourages us to spend what we earn today but also that it’s ok to spend what you haven’t yet earned today.  It’s a fairly old post now but if only people were taught to pay themselves first.  I’m the first to admit that I fell for it until I was 35 years of age.  The problem is who has an incentive to educate people about this?  The Government / Bank of England don’t, particularly now, as we’re in a spiral where they need us savers to spend.  They are actually trying to do the opposite and educate us to spend by doing all they can to erode our savings through forcing negative real interest rates upon us.  The Corporations of the world certainly don’t want you to gain this knowledge as you wouldn’t be then contributing to revenue today.  The only logical place I can see it coming from is family, friends or in very limited cases somebody stumbling across a site like this and believing what I write.  Unfortunately though it’s a spiral because if family and friends don’t know about it how can they pass that knowledge across.

Mistrust

The simple mention of two words – Equitable Life – is a good place to start.  This however is actually a symptom not the cause of the Mistrust because most Pensions don’t actually operate like this.  The actual cause is the vast majority of the Financial Services sector (which includes the FSA) who fail to educate with the full story but instead only present the side that helps them.  People are in my opinion right to go in to a Pensions transaction sceptical and mistrusting.  Let’s look at a simple example.  The website of most Pension provider’s will probably say something like the government is trying to help us save for our retirement.  If you’re a basic rate tax payer then for every £8 you invest the government will top up your pension with a further £2.  They’ll probably then go on to say if you’re a higher rate taxpayer you may be able to claim even further tax relief.  The bit they always seem to forget to inform us about is that Pensions, excluding the 25% Tax Free Lump Sum (TFLS), are actually just a tax deferral scheme.  You aren’t taxed on the way in but you are taxed on the way out.  If you’re a 40% taxpayer and plan to be a 20% taxpayer in Retirement or if your employer makes a contribution if you do then it’s probably worth it but what about the person who’s a 20% tax payer now, will be a 20% tax payer in retirement and doesn’t take advantage of the TFLS (after all it’s not compulsory and would require some knowledge to understand).  Is it worth it for him or should he just save in an ISA?.

I also feel they seem to make Pension products sound deliberately complicated to ensure that you use them instead of going DIY.  This then also enables them to maximise how much they skim for themselves without you immediately noticing.  How many people out there have and are paying large expenses today and will then find in 30 years that their Pension has delivered nothing like what they thought it would.  It’s short term thinking and self defeating but unfortunately a lot of human nature is based around greed.  Take a fair fee for helping somebody, which I actually believe some providers are doing today, then in 30 years that somebody has seen some success and so they make a recommendation to their children.  Next minute the snowball is rolling and everyone wants a pension.