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. 

Best UK Savings Account Interest Rates & The RateSetter Experiment

I have been using Yorkshire Building Society (YBS) as my Savings Account provider for a few years now.  While once at the top of the best buy league they haven’t been there for some time now.  They have however always been pretty close from an interest rate perspective and have been no nonsense from a T&C’s perspective.  I was receiving 1.5% AER meaning as Higher Rate Tax payer and with inflation running at 2.6% I was receiving a Real interest rate of -1.7%.  In other words every pound sitting in YBS was being devalued monthly.

Recently, they have sent me a letter which starts out with “As your building society, you'll know that we have a tradition of looking after all our customers with good value products and great service...” Great start but of course the small print advised that they were further reducing my savings account interest rate to 1.25% AER.

Of course I’m not surprised given the latest average savings account data from the Bank of England shown in the chart below which show instant access savings rates down 0.27% in the last year.

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Going to the market for the latest best buy savings accounts reveals very little.  Moneysavingexpert.com recommends the Santander 123 current account which has sliding scale interest rates (between 0% and 3% AER), a monthly fee and minimum deposit requirements.  The best clean rate looks to be Britannia or Coventry BS with a 1.4% interest rate but these accounts can’t be run online.

A Retirement Investing Today Review 6 Months into 2014

The June distribution laggards have now paid up so let’s take a pause to validate whether the tools and techniques from this site actually work in the real world.  This is achieved by my living the Save Hard, Invest Wisely, Retire Early mantra.  I'm a real life guinea pig putting my own money where my mouth is.  A mistake in one of my concepts could affect not only me but also my family greatly.

SAVE HARD

It’s now my sixth year of aiming to save 60% of my earnings, where earnings are defined as my gross (ie before tax) earnings plus any employee pension contributions.  Changes over the past six months mean that this target is now out of reach and a revision to a 55% target is needed.  Before you start flaming me I confirm that I haven’t been a hypocrite and started a consumerist lifestyle.  Instead the change has been caused by a healthy salary increase which is taxed at the 40% Higher Rate plus 2% National Insurance making 58% the most I could save from this new money.  Additionally, to keep my better half and I on the same financial independence trajectory this increase means I now need to cover all of the household costs as well as direct some of my savings to my better half’s investment portfolio.

In addition this half year saw HM Revenue and Customs change tune and make some aggressive demands for a tax error that they made in the 2012/13 tax year which enabled me to regularly save in the high sixties/low seventies.

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Saving hard first half score: Conceded Pass.  Without the HMRC recovery, which I’d already saved in previous periods, the savings rate would have been held.  Since sorting this the new 55% savings rate has been sustained.

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.

The RIT High Yield Portfolio (HYP) – Update and Adding PSON and RDSB

When I reach Financial Independence in less than 3 years I'm going to be presented with a number of options, one of which will be to take Early Retirement.  Should I take that option I've already telegraphed that based on my current research I will start withdrawing from my wealth at the rate of 2.5% of total net worth on retirement day.  Ideally, this strategy will have then given me the option to increase my spending at the rate of inflation annually while ensuring the pot of gold at the end of the rainbow is never extinguished.  Of course I won’t blindly follow this strategy but will instead monitor closely and should that black swan arrive will cut my cloth accordingly.

As the do I take Early Retirement question looms I also want to make sure I have sufficient confidence in my financial situation that I don’t fall into One More Year (OMY) Syndrome but instead make the decision on will I or won’t I for purely non-financial reasons.  One thing that would build financial confidence and hence take some of the do I have enough doubt away was if my dividends and interest being earned across my portfolio exceeded the withdrawal rate from the portfolio allowing some reinvestment even in retirement.  Were I to retire today I estimate that after purchasing a home and moving my employer defined contribution pension into my SIPP my dividend plus interest yield would be 2.53%.  So right on the targeted drawdown amount.  Continuing to build my High Yield Portfolio (HYP) should increase that percentage.