Sunday 28 July 2013

A Transition to Retirement

I am currently at the point where if I can maintain my current savings rate and forecast average investment return run rate I expect to have accrued sufficient wealth for full financial independence in a little less than 3 years.  This will mean I will have the option of either:

  • continuing to work in my current full time career knowing that I don’t need the company but that the company needs me; or
  • taking early retirement from my current day job which will allow opportunity for everything from doing nothing to side hustles to part time work (whether in my current or a new career) to a new full time career which might include my own business;

all at the relatively early age of 44.

With only a few years to run until Financial Independence I now believe I'm at the point where I need to start thinking about how to transition from my current position to retirement.  Before I document my first musings on what the strategy might look like to financially transition to early retirement let me first detail some relevant considerations that need to be accounted for based on where I am today:

  • I am planning to be in the position where I will need to generate no active income with all expenses being covered by investment return from my accrued wealth.  Planning this way means any work undertaken, which might earn an income, becomes an activity that brings enjoyment or learning opportunities only. 
  • I am a higher rate, 40%, tax payer and expect to be a basic rate, 20%, tax payer in retirement.  This along with the facts that as part of a pension salary sacrifice arrangement my employer adds to my pension a large part of the 13.8% Employers National Insurance Contribution that they now save, plus I also get the 2% Employees National Insurance contribution above the Upper Earnings Limit added to the Pension, means I have a lot to gain by making large pension contributions.  At current rates my pension contribution is about 50% of my monthly 60% of gross earnings savings rate.  This means that over the next 3 years, after accounting for expenses, taxes and investment types in and out of the pension, I expect my Pension wealth to move from 41% of total net worth today to something closer to 44%.  I am therefore left with only 56% of my total net worth to live off until age 55 when I can start to Drawdown on my Defined Contribution Pension.  Of course that assumes the UK government doesn't change the retirement age or other pension rules meaning I'm also carrying a bit of contingency in my planning.
  • I haven’t yet bought a home and while I will have the assets to sell to buy the home outright a small mortgage looks prudent to maximise my wealth retention by paying some short term interest payments which will allow long term minimisation of taxes.  Some of these tax minimisations will include not cashing in any of my Stocks and Shares ISA wealth as I want that tax free income forever, avoiding payment of any capital gains tax and not selling some offshore Non-Reporting Funds where the gains are subjected to income tax rather than capital gains tax, which I foolishly bought before I knew what I was doing, while I'm a higher rate tax payer.  This will reduce any Capital Gains Tax from 28% to 18% after allowing for my Annual Exempt Amount (£10,900 for 2013/14) and the tax on the gains of my Non-Reporting Funds from 40% to 20% or possibly even a portion at 0% if I'm careful.



So what’s the plan thus far?

  1. I still believe UK housing is overvalued and hence overpriced.  I don’t know if I'm wrong or right on this one but I do know that if I don’t buy before retiring gaining a mortgage might prove difficult.   I also know that I can maximise my earnings today by living in the expensive South East, which then allows me to maximise savings by living in rented accommodation, which costs a lot less than I can afford.  When I retire I won’t have to worry about maximising earnings and so intend to move either out of the South East where better property value, even if it’s still over priced, can be found along with some wonderful countryside.  Alternatively I’ll move to another European country but a bit more work and exploration still has to be done on that front.     
  2. If I stay in the UK that non-South East property will be modest in size, which will allow running costs to be minimised, but will include a little land to enable some limited self sufficiency.  Having now started looking at some non-South East regions I know roughly what that will cost at today’s prices.
  3. Considering point 1 it therefore makes sense to buy just before I retire.  By selling my NS&I Index Linked Savings Certificates, only enough equities outside of my ISA to keep me under the Capital Gains Annual Exempt Amount plus using all cash except for an Emergency Fund (ie paying no additional tax) I could today rustle up about 40% of that house cost.  Wait until just before retirement and that deposit becomes circa 70% of the house price.
  4. That leaves me requiring a mortgage equalling approximately 30% of the house price at a time when I am soon to have no more earnings.  
  5. I'm now living off my non-Pension wealth for around 11 years until age 55.  During the first few years I will live off the sales of investments that are not in tax wrappers.  I will sell only enough to keep my capital gains below the Capital Gains Annual Exempt Amount and to ensure my capital gains sales of my Non-Reporting Funds stay below the tax-free Personal Allowance which will be sufficient to provide for my lifestyle while also enabling healthy ISA contributions.
  6. During those early years what I won’t have sufficient funds for is to pay down the mortgage quickly.  To ensure I know my costs I’ll likely take a 10 year fixed rate mortgage which I’ll then let revert to the Standard Variable Rate for 1 year by which point I’ll be 55.  Now I take the 25% tax-free lump sum from my Pension, pay off the mortgage, maximise the ISA contribution in that year and invest the rest as tax efficiently as possible outside of the Pension.
  7. The remainder of the Pension fund gets put into Income Drawdown where I will drawdown the maximum permitted by the Government Actuary’s Department Drawdown Pension Tables (GAD Tables) for the remainder of my retirement.  The aim is to get as much out of the Pension as quickly as possible to minimise government meddling risk.  At current rates and based on my Pension value estimates it will just about perfectly meet my spending needs.  
  8. In parallel I’ll continue to sell off whatever non-tax efficiently invested assets I have remaining while staying below Capital Gains Annual Exempt Amount and ensure my capital gains sales of my Non-Reporting Funds keep me below the basic 20% tax rate.  This will continue to be added to the ISA whenever I don’t need it for income.


As an overview that’s about it.  I end up with a home for my family and an income stream which keeps taxes to the bare minimum.  I know it’s a very top level assessment and behind the scenes I have a lot of maths to support what I've written here.  I also know it’s based on a lot of assumptions and the world may be a different place in 1 week let alone many years but I'm also ready to alter the strategy as the world unfolds.  I also know I haven’t mentioned the State Pension.  All of my retirement planning excludes anything I might get here.  If it’s not means tested by the time I get to whatever age the government dictates I can have it then it will be considered upside.  I will however pay National Insurance Contributions during early retirement until I have accrued sufficient years for a full State Pension just in case it all goes horribly wrong.  I feel I'm planning well but the million pound question is what I have I missed?

As always DYOR. 

24 comments:

  1. Inflation in living expenses and a stock market crash?

    Personally, though I'm super prudent having lived through higher interest rates, I would not go into retirement witha mortgage

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    1. Hi Anonymous

      If you've been around these parts a while you'll know I despise debt and so I hear you when you say "I'm super prudent having lived through higher interest rates, I would not go into retirement with a mortgage." My method though aims to protect me from that risk (at least for 10 of the 11 years) by going with a fixed rate mortgage. The maths tells me that the tax saved plus potential investment return available over the term more than makes up for the mortgage interest. I must admit though that it doesn't sit well with me.

      Cheers
      RIT

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  2. BeatTheSeasons29 July 2013 at 10:03

    Good luck RIT!

    Agree that UK houses are 'overvalued' but have you considered the impact of the mortgage guarantee scheme? Basically anyone on a high income who lacks the self discipline to save up more than a 5% deposit will now be able to take on a mortgage of around 5 times their salary at a very low initial rate. Surely this is going to push up prices even more?

    The scheme is meant to run for 3 years. Depending on your exact retirement date you might find yourself trying to buy your first property at the peak of the new boom. Or you could wait for the crash that might follow once the scheme ends, but what if it gets extended or becomes permanent?

    You also have the generally improving economy, inflation and all those other factors supporting the housing market like immigration and failure to release enough land for development.

    Are you sure you don't want to buy a property now?

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    1. Thanks for the wishes BTS. You make a very good point on the Help to Sell (sorry Buy) Scheme and it's definitely a risk. I'm struggling to determine how much of an effect this is really going to have. Sure they may now get the deposit but will that be enough with real incomes falling and interest rates which they surely can't drive much lower (which is what drives affordability which is what the masses buy houses based on instead of value).

      Cheers
      RIT

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    2. The biggest factors on housing are not really immigration so much as internal demographics that require many more houses over the next ten years.

      Somehow the market has to get a signal to build more and higher prices are one way of doing that. Rents should also go up

      On the flip side house prices are high it is difficult for people on average incomes to get one.

      I suspect it is a bit of a Mexican stand-off.

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  3. i) Must you sell your ILSCs? I am a great fan of them; I look upon them as being kept for emergencies: if you don't have an emergency, remember that they are heritable. (Maybe that scarcely matters to a 44 year old, I admit.) Even the new-style ones, as long as you view each as a succession of one-year, tax-free, index-linked savings accounts, are attractive at the mo'.
    ii) At some point, babyboomers retiring and seeking to trade down must (a) lead to downward price pressure on bigger, suburban houses, and (ii) raised demand for smaller ones at the coast, near the national parks, and so on. Does this bother you?

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    1. Hi dearieme

      I'd prefer not to sell my ILSC's but to minimise the mortgage amount (and you know how much I dislike debt) it seems like the right thing to do. They will have served me well and it will be sad to see them go given it's unlikely we'll see any more on sale for a long time.

      Interesting thought on how the demographic shift could change the house price dynamic. Thanks for that as it is some good food for thought. In financial terms should that occur it would definitely bother me but on the other hand emotionally I'm getting pretty close to being done (at least for now) with big cities having lived in London for circa 15 years.

      Cheers
      RIT

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  4. Hello RIT,

    Good to see the early retirement plans are on track. I cannot imaging you doing absolutely nothing in your mid 40s so it would be good to focus on what you will want to do (rather than what you have had to do to get to this stage).

    I personally found self-employment to be very rewarding in my 40s & 50s and the idea of moving away from the South East and acquiring affordable property (with smallholding) sounds v. attractive.

    Good luck getting to the target figure - it will come around faster than you imagine!

    John

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    1. Hi John

      I suspect you'll be right and that I won't be doing nothing. The question I need to work through is will my "work" pay me a wage.

      Smallholding might be taking it a bit far :-) I am however attracted by the possibility of fruits and vegetables that aren't soaked in pesticides and which have some real flavour. If growing them myself then saves me some money then so much the better.

      Cheers
      RIT

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  5. I think you have thought this through pretty well. The only caveat I have is your cash ratio. Won't this go down if you sell your ILSCs? How would you feel in, say, 5 years if there was a huge market crash?

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    1. Hi SG

      Great to hear from you. It's been a while. Rightly or wrongly I actually allocate my ILSC's within the Bonds portion of my portfolio and not Cash. Once I sell my ILSC's I will be very underweight bonds but will be certain to rebalance back to my risk tolerance immediately. This will easily be able to be done tax effectively within the ISA and Pension.

      Cheers
      RIT

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  6. Very interesting post - thank you.

    I'm interested in what assumptions you are making here. Here's a list as it strikes me, along with my gut assessment:
    1) Stable inflation. OPTIMISTIC. I am not a massive inflation bear, but you are talking about being retired for (touch wood) longer than you have been alive to date. In that period, something bad will happen. That could easily be high inflation.
    2) Stable interest rates. PLAUSIBLE/mitigated. Linked to (2), and your 10 year fix should reduce your exposure. And in fact higher interest rates are probably upside for you, provided they aren't accompanied by massive inflation.
    3) Stable property prices. PLAUSIBLE, at least insofar as gentle long-term increases are assumed. I think your assumptions about the South East vs the rest of the UK are right. And while it is possible prices and rents keep heading up, at some level political pressure will enforce some sort of sensible correction if necessary. But I think you are better off owning at least something you could tolerate living in, as a hedge against nasties happening (and as a potential income stream).
    4) No change in tax rates. PLAUSIBLE, at a high level. Though I think you may get slightly hit by tightening limits (or fiscal drag) on capital gains tax thresholds in particular.
    5) Stable pension/etc regulation. OPTIMISTIC. In particular I think you are a bit vulnerable to the age 55 limit being raised, the ISA annual allowance (or lack of lifetime limit) being tightened, and possibly the higher income tax relief being reduced.
    6) Stable currency rates. OPTIMISTIC. Your view is very UK specific (with the exception of living abroad, see below). If the pound halves in relative value (which it has a long term trend of doing), can you cope? No more foreign holidays / foreign cars; cheaper wine ;-) Hopefully your investments give you some non-UK exposure which should hedge you against this risk.
    7) Continued UK EU membership. PLAUSIBLE. Your ability to buy property / move to another European country may stop post 2017. Tho somehow I doubt it.

    Overall I think your strategy feels sound, albeit rather nerve-wracking - given the length of time you plan to be living 'in retirement'. But I think you have plenty of sources of potential upside, so good luck!

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    1. Hi William

      Thank you for the well reasoned and detailed reply. Plenty of food for thought. Some initial from the hip thoughts from my side:
      1. I predominantly hold Equities and Bonds in my portfolio. Should we get high inflation I am relying on the companies I hold within my trackers and HYP being able to raise prices in line with inflation. On the bonds front I hold ILSC's and Index Linked Gilts so should be relatively well protected. I do however take your point and should we get Weimar style inflation I'm sure I'll be in big trouble but then so will everyone else - retired or otherwise.
      4. Agreed on the fiscal drag problem. When running my numbers in the background I have am building some contingency in for just this type of problem.
      5. Agree I'm vulnerable to pension changes and need to watch this carefully. Trying to protect myself by keeping pension as small a portion of wealth as possible but all the benefits are currently making pension contributions a very attractive proposition at this point in my work life. Current analysis suggests I'd be in big trouble if 55 was to become 60.
      6. Hopefully you've seen my Strategy (My Low Charge Portfolio tab below site banner) which I believe has me fairly well protected here.

      Cheers
      RIT

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  7. Great Article it is really helpful. I must appreciate it, Thanks for sharing :)

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  8. Here's just the investment for a stripling of 44.
    http://blog.redington.co.uk/Articles/Guy-Whitby-Smith/July-2013/ULTRA-LONG-LINKER-SYNDICATION,-2068-LINKER.aspx

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    1. :-)
      I guess while UK PLC has interest rates manipulated to record lows it makes sense for UK PLC to take advantage of the manipulation by locking debt in at a low rate for the longest possible time.

      Delete
  9. Hello RIT. Firstly, many thanks for your website and your obvious ethic to share knowledge without seeking profit. This is so rare within the finance community and really quite refreshing.

    I see that you are now seriously considering house buying. I really do not know what the current availability is with offset mortgages but do take a look just in case. You can keep your emergency cash sitting in a bank account offsetting your mortgage and also available should you need it in an emergency. If the option is still available, your current account will offset, too (it all adds up over the years). Same goes for the pension lump when you get it; you can keep it available to you by offsetting instead of paying off the mortgage.

    When we obtained ours, the deal I found I considered brilliant for people who were sensible about money management (and a potential noose for those who live over stretched). We purchased our house at the end of 2005 with a mortgage 35% of the buy price (I am 38 now). Our mortgage is/was a 25yr interest only tracker offset, bank base rate + 0.59%. Our current account is counted towards offset. We do consider ourselves lucky that interest rates have worked in our favour (and there is no way you could get such a good % above BBR at the moment) but we have always had the option to liquidise savings/assets elsewhere and convert to offset cash should interest rates rise above a certain level that would affect our monthly expenditure.

    Another benefit to using emergency cash as offset is that the offset rate is effectively tax free. Of course, this is only a benefit if the mortgage rate is comparable with a non-offset alternative. As time went by, our savings amounted to somewhere we could pay off the mortgage but, instead, we added value to the house and our living style by extending and making home improvements. At that point, we had the option to consider it very reasonable that we would build up enough savings (away from that put aside for retirement) from scratch again. I do not think the house worth has increased the same as the amount we spent but we are very happy with the improvements!

    I hate debt, too (it took me years to get my head around why any company would actually give someone a credit card), but this type of mortgage has given us real flexibility.

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    1. Hi Unknown

      Thanks for the vote of confidence and thanks for sharing your own personal experience/situation. This is one of the reasons I started this site - to hopefully teach readers things I've learnt (both good and bad) while also learning from readers. This becomes particularly fulfilling when it is learnings that aren't available through the mainstream media and financial services sector who benefit from us not knowing.

      Cheers
      RIT

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  10. I've no experience of offset, but there is, or there was, a deal called "flexible interest-only mortgage" that we've had for ages. When we've been flush, we paid the mortgage down; when we needed the moolah, we borrowed it back. The interest rate has been 2% above bank rate, which is less awe-inspiring than Unknown's but is still pretty good. The flexibility has been a huge convenience and comfort.

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    1. Thanks for sharing dearieme. I'll be sure to investigate when the time is right.

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  11. Well done! Looks like you have your ducks in a row on the finace side. While there are different calls one might make according to individual preferences, it sounds like you have it well nailed in terms of reflecting your view of the future.

    Something you might want to ponder over the next three years is your human setting. Who do you want to stay in touch with, who would you be better off without, what avenues and with whome do you (and any significant others) want to explore and get to know?

    Moving isn't all about money, though getting out of the south-east seems a no-brainer. If in the UK, you might want to keep in mind somewhere with good connections to London, particularly rail. Having control of your own time means you can take advantage of some deals, and also international travel from the UK seems still horrifically London-centric.

    With respect to offset and flexible mortages, bear in mind that if your circumstances change (like stopping work), the mortgage company Ts and Cs sometimes let them impound the offset savings. Modern credit scoring seems to have no understanding of non-income income (ie where you don't work for it), leastways at the ordinary grunt level, because it's so rare.

    But these are details. Sounds like you have the big picture all set, and honing the details are what the next three years are about. Fantastic, and good for you!!!

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    1. Hi Ermine

      A very good point on pondering the human setting and moving isn't all about money. Behind my public persona on this website I am considering and working on these types of issues. (Too be honest though this is an area I find more difficult also as I am very much a quantitative rather than qualitative person.) I tend not to publicise this type of detail too heavily on this site for a few reasons:
      - I try and keep the site generally about personal finance rather than just a blog of my journey. Occasionally I stray with some off topic content or the odd rant but on the whole I "hope" I achieve that goal. One thing I do however hope doesn't occur is that readers think I'm a robot and not human which is of course the risk of my approach.
      - At this time in my life I think it's sensible to stay anonymous on this site. When I retire I may publicise who I am but I have some time to make a final decision. By sharing too many personal thoughts publically I run the risk of being identified.
      - As mentioned above it's not a natural skill for me and so there are plenty of other websites with much better content than I could produce.

      Cheers
      RIT

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  12. I'm also planning an early retirement, I'm 36 and planing to retire in a maximum of 5-7 years.

    I big question for me is where? Because I have a young daughter and I need to consider, education, safety etc...

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