Taking a multi-asset approach to retirement income
Introduction
This briefing looks at how a multi asset approach using accumulated investments, including pension funds, can support a more tax efficient income in retirement, helping to preserve savings for longer.
Core considerations
- Holding a range of savings and investments across different tax wrappers and where possible held across spouses or civil partners can help in using all the available tax allowances and provide a more tax efficient and sustainable approach to income generation.
- If there is an Inheritance Tax (IHT) liability using assets subject to IHT first can also help to reduce any IHT payable.
- Pensions can be used in several ways – by using tax free cash and drawdown or a combination of both.
- Investment strategy is key – with assets matched to short term income needs and longer term growth.
Contents
The right investment strategy
This will be vital in meeting the income needs set by clients. This may be achieved through a blended approach to investment or through specific portfolios – for example short-term, medium-term, and long-term funds.
Pound cost ravaging
This happens when income drawn continues when asset values are down. For example, if 9% of withdrawals are being taken from a £100,000 fund (i.e., £9,000) then if this same level of income is drawn when an invested fund is valued £90,000 this equates to a 10% withdrawal which will reduce the assets available to help the investment recover in the future. If a 9% withdrawal was to be maintained the amount drawn would need to reduce to £8,100. This impact could be mitigated by holding an amount in cash to cover short term withdrawals to avoid drawing on longer-term investments during market downturns. However, that cash will need to be replenished and replenishment would need to wait until the markets recover for this strategy to be successful.
Example – Frank and Anna
Frank is married to Anna; they are both 66 years old and in good health and about to retire. They have no debts, a property valued at £775,000 and they have accumulated several investments over the years. They have been careful to invest across different tax wrappers with a diversified portfolio and split equally between themselves, each holding:
| £20,000 | cash on deposit |
| £20,000 | cash ISAs |
| £115,000 | stocks and shares ISAs |
| £20,000 | growth OEICs generating 2.5% per annum in dividend income |
| £250,000 | onshore investment bond |
| £300,000 | personal pension |
They want flexibility to change their income levels now and in the future - for example if they become less active in their later retirement years. They also want to ensure that if either or both die their spouse or heirs can benefit from their retirement savings.
They want joint income after tax of around £30,000 per annum in addition to their State Pension. The Office of National Statistics suggests that Frank’s life expectancy is to age 85 and Anna’s to age 87 but there is a 1 in 4 chance that either or both will survive into their 90s and beyond. Based on average mortality, their savings and investments need to provide them with income for more than 20 years.
The income from their savings and investments will be taxed as follows:
| Interest from cash on deposit @ 3% = | £600 within 0% savings rate |
| ISAs = | no tax to pay |
| OEICs 2.5% on £20,000 = | £500 within 0% dividend tax rate |
| Bond = | up to 5% withdrawals tax deferred |
| Pensions = | up to 25% tax free, remainder taxed as income |
Frank and Anna want to retain the interest paid from their cash on deposit.
Frank and Anna’s immediate thought is to draw from their pension funds to provide them with the income they need. They have no immediate requirement to generate a lump sum, so it makes sense to use that tax-free element to support their income needs in a tax efficient way.
If Anna and Frank do this, they will need to generate £15,000 income each year in addition to their State Pension of £10,600. This could be achieved by drawing down around £17,200 each from their pension funds.
Anna and Frank’s position would be as follows:
| Income source | Tax status | Anna annual income net | Frank annual income net | Joint income net |
|---|---|---|---|---|
| Pension 25% of £17,200 | Zero tax | £4,300 | £4,300 | £8,600 |
| Pension 75% of £17,200 taxable |
(£12,570 - £10,600) = £1,970 within personal allowance. Remainder (£12,900 - £1,970) is taxable. |
£10,714 | £10,714 | £21,428 |
| Total income | £30,028 |
Using this approach Anna and Frank do generate the income they need but will pay income tax totalling £4,372 (£2,186 each) on an ongoing basis. They will also be drawing on funds that could be passed on to their children free of Inheritance Tax.
The benefit of Anna and Frank’s diversified approach to investment means that it is likely (based on current tax rates and allowances) that they can generate the income they need without creating any immediate tax liability.
Instead Anna and Frank could take:
- 3% withdrawals from their bonds which generates tax deferred income (with no immediate tax to pay) of £7,500 each. This level of withdrawal should be sustainable for more than 20 years, providing them with a degree of security in relation to their longevity and/or inflation-proofing.
- The £500 income generated from each of their OEICs provides them with an additional amount of income which is also free of tax as it is within their dividend allowance. This is natural income so will not be eating into their invested capital within the OEIC.
- £3,500 could be drawn each year from their stocks and shares ISAs which again around 3% and should be sustainable as well as being free of tax.
- £2,600 could be taken from their pension, of which 25% (£650) is tax free, and £1,950 taxable. However, as Frank and Anna’s only other income is their State Pension of £10,600, this leaves enough of their personal allowance to mean that there will be no income tax to pay it.
Anna and Frank’s position can therefore be summarised as follows:
| Income source | Tax status | Anna annual income | Frank annual income | Total income |
|---|---|---|---|---|
| OEIC | Within dividend allowance – zero tax | £500 | £500 | £1,000 |
| Bond | Within 5% withdrawals – zero immediate tax | £7,500 | £7,500 | £15,000 |
| Stocks and Shares ISA | Zero tax | £3,500 | £3,500 | £7,000 |
| Pension UFPLS | 25% tax free, 75% taxable but within personal allowance so zero tax | £2,600 | £2,600 | £7,200 |
| Total income | £30,200 |
As a result of taking their income from across their savings and investment pots, Frank and Anna will save tax of £4372 each year.
In addition, drawing on the assets which are assessable to IHT (ISAs, OEICs and bonds) rather than focusing on their pension funds particularly in the earlier years of their retirement may help to reduce any liability to IHT on second death.