This is part three of a series on how to maximise your ISAs and SIPPs to achieve financial independence. Part two explained why the tax advantages of personal pensions make them superior to ISAs later in life. Be sure to also read the first part of the series.

To make the most tax efficient use of your savings, your ISAs need only fund the years between early retirement and your minimum pension age.

Obviously it’d be marvellous if our ISAs piped hot income streams into our lives long after that, but our primary concern is to fund them so we’re unlikely to run out of money before our personal pensions take over.

That’s because there’s no point oversaving into our ISAs, either. That would see you delay financial independence by paying tax that would have instead been clawed back through pension tax relief and added to your growing nest egg.

The ISA/pension balancing act

Should investment returns turn out to be poor, we would expect our ISAs to be running on empty as we dock with our SIPPs.1

We would then discard the ISAs like empty booster rockets and ride on using our SIPPs, and eventually a State Pension slingshot.

To put that plainly:

Phase 1 – You need to be able to draw all your income needs from your ISA / taxable accounts without fear of running out of money,2 until you reach the minimum pension age.

Phase 2 – You need to be able to draw all your income needs from your personal pension, once you can access it, without fear of running out of money until you die.

Lifeboat – It’s quite likely the State Pension will provide some support later in life. The lower your income, the older you are, and/or the sketchier your plan, the more important the State Pension becomes.

We’ll construct the plan so the State Pension is primarily a back-up and, later in the series, we’ll draw upon research that shows how you can adjust your plan to account for it.

How much income and for how long?

How much annual income do you need in retirement? And how many years do you need it to last?

These are the big two questions to answer for each phase of our plan.

Guesstimating your required retirement income is not so hard, especially if you already track your expenses.

Let’s say you’ve decided you’ll need £25,000 per year for the rest of your life. (We’ll assume all calculations are in real terms, so we’re accounting for inflation.)

How much wealth do you need in your ISA to sustain £25,000 in annual income?

It depends on how long you need that income to last (Phase 1) before your pension income becomes available (Phase 2).

There are two basic ways to fund your Phase 1 pre-pension, post-retirement income:

1. The usual sustainable withdrawal rate (SWR) approach – a portfolio of mixed assets in your ISA that you ‘create’ an income from by selling a planned proportion each year.

2. Liability matching – a big pot of cash or bonds3 that won’t grow much or at all after-inflation, but that starts out big enough to take your desired income from each year until you can crack open your pension.

Let’s look at both in turn.

Method #1: Drawing down an ISA portfolio

The infamous 4% rule says we need to build wealth that’s worth 25 times our annual income requirement to become financially independent.

25 times your assets comes from: 1 / 4 x 100 = 25

£25,000 x 25 = £625,000

So we need £625,000 to take an annual, inflation-adjusted income of £25,000 at a 4% sustainable withdrawal rate (SWR).

But the 4% rule applies specifically to 30 year time frames.

What if you only need your ISA to last ten or 20 years until your personal pension comes on stream?

Then your sustainable withdrawal rate (SWR) from your ISA can be higher.

Let’s say you can use an 8% SWR to sustain spending from your ISA for ten years.

We can save much less into our ISA in that scenario:

1 / 8 x 100 = 12.5

£25,000 x 12.5 = £312,500

Now we only need ISA wealth of approx £312,500 to draw an income of £25,000 for ten years. After that, we will look to rely on our personal pension income, if our ISA is exhausted.

Bear in mind that a SWR calculates the maximum amount you can take from your portfolio without running out of money, based on historical returns data. (Terms and conditions apply.)

In most scenarios, you actually end up with a healthy surplus in your account when you use an appropriate SWR, even if your retirement was blighted by economic times of darkness such as the Great Depression, Stagflation, and the World Wars (provided you were on the winning side).

Nonetheless, we want a plan that minimises the chances of being forced back to work against our will.

We’ll therefore use cautious SWRs throughout this series that suit our possible timeframes – no matter if we need our tax shelters to last ten years or 50.

Method #2: Liability matching

The safest way to fund your retirement is to match your future expenses (liabilities) with a treasure chest of near risk-less, guaranteed income.

A ladder of inflation-linked bonds would be ideal.

In the ISA example above, a tranche of your bonds would mature every year, depositing £25,000 of inflation-adjusted income into your account for each of the ten years until you can access your pension.

Alternatively, you could save up enough cash to cover the ten years, remembering to factor in an allowance for inflation.

Liability matching with low risk assets generally requires more capital than investing in an equity heavy portfolio. The more resources you have, the less growth you need, and the less risk you need to take. It’s a trade-off.

My assumptions suggest that it’s likely quicker and safer for everybody to save cash4 to bridge an eight-year gap or shorter, between Phase 1 and Phase 2.

I’ll go into more detail on this later in the series.

Minimum pension age

Our ISAs need to span the gap between our early retirement age and our minimum pension age – the latter being when we can officially smash open our defined contribution pensions like piñatas.

Which will be when exactly?

Unbelievably – ahem – that’s not so easy to pin down.

Currently you can get into your defined contribution personal pension from age 55.

But the 2014 Coalition Government (remember them?) indicated that the minimum pension age would rise to 57 in 2028. Your minimum age would then be set to ten years before your State Pension age, from then on.

Thing is, they didn’t get around to legislating the minimum pension age change. So it’s not yet law. And then Brexit happened. Eyes were taken off the ball. Now no one knows what’s going on.

We don’t know whether the rise in the minimum age will take place as mooted. But many industry insiders say the change is still coming and can be legislated whenever the government likes, so it’s best to assume the worst.

If you were born in 1972, you will be 55 in 2027, so you should be fine, right? You can tap your pension in 2027 before the minimum age hikes to 57 in 2028.

Not so fast. There has been talk of tapering the change in. It could be you’re still caught out, even if you’re 55 a few years before 2028.

It’s a mess.

We’ll play it safe by assuming that our minimum pension age is set to ten years before our State Pension age for the purposes of the upcoming and unbelievably exciting case studies we’ve got planned for this series.

These case studies will also show how to calculate how long your ISAs will need to last (roughly), given your current circumstances.

How much do you need in your personal pension?

By the time you retire, your portfolio – when combined across all accounts – should be funded to last the rest of your life. How long might that be? If you’re age 60 or less today then you have at least a 10% chance of living to age 98 according to UK life expectancy data – unless you have good reason to think otherwise. There’s an even greater chance that one of you could survive if you’re part of a couple.

SWRs tend to reduce over longer periods of time, but the curve flattens out. Multiple research papers point5 to a 3% SWR being suitable for retirements of forty years and over – which likely accounts for the majority of people on the FI fast track.

Carrying on the £25,000 retirement income example, the wealth needed to sustain lifetime spending for over 40 years at a 3% SWR is:

1 / 3 x 100 = 33.333

£25,000 x 33.333 = £833,325.

We’ve established that the ISA portion of this wealth target needs to be £312,500 to ensure it doesn’t run out before the pensions come on stream ten years later.

Therefore, your personal pensions need to be funded to the tune of:

£833,325 – £312,500 = £520,825 by the time you pull the trigger.

My thanks to Monevator readers Aleph, Naeclue, and Oxdoc whose dogged persistence corrected my mistaken assumptions when this article was originally published.

Other income streams – So you’ve got other income streams like buy-to-let property and defined benefit pensions to tap into? Lovely. Just deduct those additional income streams from your assumed retirement income when they’re available. Your portfolio will only need to cover the remainder. We’ll cover the State Pension and DB pensions that become available further down the track at a later point in the series.

In the next post, we’ll cover how to choose a credible SWR that matches your personal timeframe and accounts for a low interest rate world, non-US investment returns and the implications that has for your asset allocation in retirement.

Take it steady,

The Accumulator

1. Self Invested Personal Pensions. [↩]
2. We mean without fear on a practicable level. Ultimately there is no absolute safety. [↩]
3. We’re talking a ladder of individual bonds (not a fund) with staggered maturity dates. Each tranche of maturing bonds delivers a payload of capital to match your income needs per year you need to fund. Inflation-linked government bonds are best. A Purchase Life Annuity could also conceivably fit the bill. [↩]
4. A lack of suitable bonds makes it hard to build an inflation-linked bond ladder in the UK. [↩]
5. We’ll cover the research in more detail in the next episode in the series. [↩]

What caught my eye this week.

The IT Investor has a honeypot of a post up this week for active investing junkies. He’s dived into his investment trust data to sieve out what he’s calling ‘double doublers’ – investment trusts that doubled their share price in the first half of the last decade, then did it again in the second.

It sounds spectacular – it is – but qualification requires ‘only’ about a 15% return a year. You could have got a slightly better return from a US S&P 500 index fund, and many passive investors did.

The best double doublers did even better though, and the result is catnip for an active investing sinner like me. (Reminder: it’s my co-blogger The Accumulator who is Mr Passive).

Here are IT Investor’s top five double doublers:

What’s particularly galling is I owned four of these five trusts at some point in the last decade – but I hung on to none of them for anything like ten years.1

The curses of active investors are indeed many and various. They’re not just down to the fact it’s a zero sum game, which guarantees net disappointment for average pot of money, after costs and fees. There’s also the way that even when you get it right, sooner or later it turns into wrong.

How so?

Well maybe you sell too soon. Or maybe you realize you should have bought more. Or dozens of variations on the theme. Stock picking is not a hobby for anyone who occasionally brings a box of old love letters down from the attic to tearfully wonder what might have been.

But it’s not a game for those who wouldn’t even keep the letters of their old flames, either. If you’re that rational, buy the market!

I did it my way

Despite all this, until we grow bored or are physically restrained, some unfortunates like me will always be there to continue the quixotic quest of trying to beat the market. If you want more ways to understand why, Robin Powell tackles the subject in a guest post on Humble Dollar this week.

Robin cites Meir Statman, a finance professor at Santa Clara University, who gives several good (/bad) reasons including this particular bugbear of mine:

Many investors, Statman says, frame their returns relative to zero, rather than relative to the market return — the performance they could have earned by investing in a low-cost index fund.

“A 15% annual return is excellent,” he says, “but it is inferior when an index fund delivers 20%.”

It’s been at least a decade since I’ve taken seriously any active investor who doesn’t benchmark properly. Yet go to a meet-up and you’ll find they abound.

Perhaps that’s because as the wonderfully-named Professor Statman says, many of us:

…need to feel that we’re better than average.

And nobody active investing to that end wants a number telling them otherwise!

Have a great weekend.

[continue reading…]

1. I currently own only Lindsell Train off this list. [↩]

This is part two of a series on how to maximise your ISAs and SIPPs to achieve financial independence. Part One explained why you shouldn’t just target a single Financial Independence ‘number’ when you need to make the most efficient use of multiple tax shelters.

Most people, young and old, should exploit their personal / workplace pension options, from SIPPs to Master Trusts, even if they’re aiming for rapid financial independence.

Before I explain why, a quick reminder:

• ISA money is taxed before it goes into your account but not when it’s withdrawn.

• Pension contributions are taxed when withdrawn, but not when they’re put in.

I’m simplifying a little, but essentially that’s the case.

The timeliness of taxation offers no advantage to either ISAs or SIPPs.

An ISA that taxes you at 20% on the way in and 0% on the way out would leave you with exactly the same amount invested as a SIPP that taxes you at 0% on the way in and 20% on the way out.

The maths makes no difference to your investment returns if the tax rates are the same, as The Investor has showed.

But SIPPs beat ISAs and LISAs because the tax rates are not the same.

The comparison below is the simplest way I can think of to illustrate.

Why SIPPs beat ISAs and LISAs for maximizing post-tax returns

In each of the following scenarios, the number in pence is what you have left from £1 gross – once tax is deducted on the way in and/or on the way out.

ISA savings – Basic Rate taxpayer

Each £1 is first taxed at 32% (20% income tax + 12% National Insurance contributions):

£1 x 0.68 (32% tax on way in, 0% tax on way out)

= 68p left

Your ISA leaves you with 68p for every £1 gross you contribute. (Remember, we can ignore investment returns because they will be the same for every account in this comparison, and the timeliness of taxation makes no difference.)

SIPP savings – Basic Rate taxpayer

Each £1 is first taxed at 32% (20% income tax + 12% National Insurance contributions):

£1 x 0.68 (32% tax) = 0.68

But there is tax relief:

0.68 x 1.25 (20% tax relief) = 0.85 (85p is left from £1 gross on way into SIPP)

£0.85 x 0.85 (15% average tax paid on SIPP income after 25% tax-free withdrawal and 20% Basic Rate tax paid on the remaining 75% of income) = 0.7225

= 72p left

So the SIPP leaves you with 72p on the £1, whereas the ISA leaves you with 68p, in a comparison I deliberately skewed against the SIPP.

How skewed?

Well, in reality some of your SIPP income will be withdrawn tax-free using your Personal Allowance (PA). I also haven’t factored in the benefit of salary sacrifice or employer contributions. (I appreciate they’re not available to everybody).

SIPP savings – Basic Rate taxpayer, including Personal Allowance

The SIPP advantage improves dramatically when you account for tax-free Personal Allowance withdrawals of income.

£1 x 0.68 (32% tax) = 0.68

0.68 x 1.25 (20% tax relief) = 0.85

£25,000 income withdrawn from SIPP:

£25,000 x 0.75 (after 25% tax-free withdrawal) = £18,750 taxable income

£18,750 – £12,500 (Personal Allowance) = £6,250 taxable income

£6,250 x 0.2 (20% tax) = £1,250 tax paid

1,250 / 25,000 x 100 = 5% average tax paid on income

£0.85 x 0.95 (0.85 is left from £1 gross on way in, 5% tax average tax paid on way out)

= 80p left

In this scenario, the 80p you get out of a SIPP is worth over 17% more than the 68p dispensed by an ISA. Mileage varies depending on how much you withdraw from your SIPP in any one tax year.

The effect of National Insurance is also interesting here. Tax relief examples generally show 80p being grossed up to £1, or £1 being grossed up to £1.25, to show you how 20% tax relief works. (Just multiply your net figure by 1.25). But much depends on how your pension contributions are deducted.

In a scenario where every £1 gross is down to 68p by the time it hits your bank account, after income tax and National Insurance, then things don’t look quite so good. Put 68p into your pension, multiply by 1.25 and you’ve got 85p. That’s much better than an ISA but salary sacrifice – which enables you to sidestep National Insurance – is a powerful benefit if your workplace offers it, and if your pension contributions would ordinarily be taxed at the Basic Rate or higher.

SIPP savings – Basic Rate taxpayer, including salary sacrifice and PA

Here’s the same scenario again boosted by salary sacrifice:

£1 x 1 (salary sacrifice = no tax on the way in)

£25,000 income taken from SIPP:

£25,000 x 0.75 (after 25% tax-free withdrawal) = £18,750 taxable income.

£18,750 – £12,500 (Personal Allowance) = £6,250 taxable income

£6,250 x 0.2 (20% tax) = £1,250 tax paid

1,250 / 25,000 x 100 = 5% average tax paid

£1 x 0.95 (£1 gross on way in, 5% tax on way out)

= 95p left

Lordy! Now your SIPP funds are worth 40% more than your ISA’s at 95p vs 68p on the £1.

And we still haven’t thrown in employer contributions – in short, just bite their hand off whenever available.

Wealth warning Salary sacrifice can leave low earners out of pocket, and it has wider ramifications for other employment benefits. Check this link for more on salary sacrifice and pension tax relief in general. Salary sacrifice can also be a quagmire for high-earners colliding with the tapered annual allowance. That’s a whole other kettle of articles.

I won’t bore you with all the permutations but here’s another couple of useful examples:

If you took a £50,000 SIPP income in the above scenario, you’d still have 90p on the £1.

Take £50,000 and you’re left at the top of the Basic Rate tax band on £37,500, after deducting your 25% tax-free withdrawal. Deduct another £12,500 for the Personal Allowance and only £25,000 remains taxable at 20%. £5,000 tax divided by £50,000 income means you pay an average tax rate of 10% – leaving you with 90p on the £1.

A Higher Rate taxpayer is left with just 58p on the £1 from an ISA.

What about a Lifetime ISA?

LISA savings – Basic Rate taxpayer

£1 x 0.68 (32% tax on way in)

0.68 x 1.25 (25% gov boost) = 0.85 (0% on way out)

= 85p

LISAs are good for saving for a house but are generally worse than SIPPs as a retirement savings account. You can’t access it until age 60 for retirement without taking a 25% penalty charge, and personal pensions also trump LISAs when you consider inheritance tax, means-testing, and bankruptcy scenarios.

If retiring before the minimum pension age (when you can access your personal pensions) means putting everything you can into your ISAs then forget about your LISA.

If you want to create more tax-free income from age 60 and you’re maxing out your pension’s Annual Allowance, or are worried about hitting your pension Lifetime Allowance then LISAs come into play.

Defined benefit (DB) pensions add another level of complexity, and now is not the time to get bogged down in it. Ultimately DB pensions take pressure off your personal pension, and hopefully the series will give you enough knowledge to see how they fit into your own plan.

There may be some people who discard personal pensions because they aim to retire extremely early, or some other unusual circumstance applies.

But most people will be better off using a personal pension to fund much of their later life from the minimum pension age on.

In the next post in the series, I’ll explain how to work out how much you need to put in your ISA versus your personal pension to hasten financial independence.

Take it steady,

The Accumulator