Retirement planning for three key life stages

Retirement generally requires careful financial planning. Your plan can be mapped out right from your early working life and, for many of us, it will extend into the retirement period itself.

Our unique circumstances will shape our retirement plans. Despite these diverse circumstances, we fall into three broad retirement planning categories:

• Pre-retirement

• Approaching retirement

• In retirement.

This article looks at each of these three categories in detail.

Let’s start by pointing out that some financial planning requirements hold for our entire adult lives. Quite simply, we believe we generally stand in need of the following:

• A sound financial plan, no matter what stage of life we are in

• Cash flow modelling, a practice that enables us to estimate our future financial requirements and assess whether we are on track to meet them

• Regular reviews with an adviser would benefit many of us

• To make appropriate use of the tax allowances offered to us by the government.

Pre-retirement: start early

At Schroders Personal Wealth (SPW) one of our key principles is to invest for the long term and avoid holding unnecessary cash, as cash typically produces lower returns. That said, keeping a cash reserve of what you would expect to need to live off for six months, is sensible. Long-term investors can benefit from compounding. With compounding, the returns from investments are themselves reinvested, which can potentially enhance investment gains over time.

The earlier you begin your investment journey, the more you can benefit from compounding. So people in the pre-retirement phase could potentially benefit from starting their retirement plans as early as possible.

Large outgoings

Many of us are heavily stretched in the pre-retirement phase. We may be bringing up children, holding down a mortgage, and possess limited opportunities to invest for the future. This life stage involves weighing up how much you can invest for the long term and harnessing tax-efficient products, such as pensions and ISAs.

Employees can try to make the largest appropriate contributions they can into their workplace pensions. And it’s worth remembering that many employers will increase their contributions (up to a limit) into staff pensions when employees increase their own contributions.

In his March 2023 budget, chancellor Jeremy Hunt increased the annual pensions allowance from £40,000 to £60,000. You may, if appropriate, want to increase your pensions contributions to take advantage of this allowance.

Pension contributions, up to certain limits, are removed from income for tax purposes. So higher or additional rate taxpayers may benefit from making pension contributions in order to avoid falling into the higher tax bands.

Couples could equalise their pensions

With some married couples, one spouse works full time and builds up large pensions savings, while the other spouse brings up the children and/or works part time and has smaller pensions savings. There may be benefits, where possible, in trying to make their pensions savings more equal, as they may then collectively pay less tax when they finally come to draw on their pensions.

And remember, if one spouse isn’t working they can still put £3,600 a year into pension. According to pensions tax rules, the pension provider will claim tax relief for this spouse at a 20 percent rate, meaning the government will, in effect, contribute £720. So this spouse will only need to make an annual pension contribution of £2,880 and the government contribution will bring it up to £3,600.

In addition, the non-working spouse may be able to get qualified National Insurance child benefit credits for the state pension, even if they don’t meet the criteria to receive child benefit. These credits could boost their state pension in the future.

Options for business owners

If you run a business, you may have more scope to take pension contributions from each spouse. One spouse may run the business while the other has a smaller role in the company. Trying to level up the pension contributions from both could improve the couple’s overall tax efficiency.

Moreover, when business owners put money into their own pension this can, in certain circumstances, reduce their company’s corporation tax liability. But the rules here are complex and revolve around whether or not the pension contributions are ‘wholly and exclusively’ for the purposes of the business. Broadly speaking, this means contributions should be at a reasonable level for the pension holder. You may want to seek advice from your accountant or tax adviser if considering this approach.

In the pre-retirement stage, you may benefit from investing tax efficiently in ISAs. A couple who each invests the current maximum allowable £20,000 a year in ISAs would have invested £800,000 (excluding investment performance) after 20 years.

Higher earners could also consider Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs). VCTs and EISs offer tax relief but they are considered higher risk and you may want to seek advice before investing in them.

If you receive an inheritance in the pre-retirement stage, then you may want to set some of it aside as a long-term investment. You could use it to make use of your tax allowances and, if you are married or in a civil partnership, you could use your partner’s tax allowances as well.

Approaching retirement: get your ducks in a row

The period leading up to retirement is your last chance to save for the future, as these are typically your final years with a salary.

At this point you may well have a reasonable ‘capacity for loss’, which means that any investment losses could have a relatively minor impact on your standard of living. But this capacity for loss reduces sharply once you stop working, as you then typically have no income to replace any investment losses.

Invest surplus income

At this point in your life, you may well have paid off the mortgage and perhaps put children through university. So you might have surplus income, which could be diverted into a savings plan.

It’s very easy to dip into savings if they’re held in cash. But a direct debit going into a regular contribution investment feels rather like an outgoing, so it functions as a kind of ringfence around surplus income. You could try to invest on a monthly basis: saving £1,000 a month for seven years would amount to £84,000 invested (excluding investment performance).

The point is to try to save as much as possible when you aren’t reliant on all of your income so there will be more available when you are dependent on it. It’s the last opportunity to boost your pension pot or ISA savings and get the tax efficiency that comes with them. Similarly, for higher earners who are willing and able to accept a higher level of risk, this may be their last chance to benefit from the tax relief that comes with VCTs or EISs.

When looking to retire it’s a good idea to think about getting your ducks in a row in advance. Work out your requirements. Prioritise what goals are important to you, establish whether you have the means to achieve these goals and what adjustments you might need to make if you don’t have sufficient means. In retirement you are often no longer accumulating, but you are trying to get the most from your savings.

Choose your retirement approach

Decide on when you are going to retire and plan for it in advance: we believe it is crucial to make plans in the five or so years running up to retirement. Then decide on your retirement strategy.

If you have a defined contribution pension, in which you build up a pot of money that you can use to provide an income in retirement, then you have two main approaches. You might continue to keep the pension pot in investments but make withdrawals from it to provide a retirement income, an arrangement known as drawdown. Alternatively, you could buy an annuity with your pension pot. An annuity is a product that will pay either an income for life or for an agreed number of years. For some people, a combination of the two approaches may be the right solution. There are pros and cons to each approach, which we cover in more detail below.

Review any company pensions

Many company pension schemes use what are known as ‘derisking’ strategies. In these cases, the underlying assets in the pension fund become increasingly lower risk as you approach retirement age. This could, for example, be achieved by reducing the allocation to equities (shares) and increasing the allocation to government bonds. The idea here is to attempt to maintain the value of your pension fund as you approach retirement.

If you opt for drawdown instead of an annuity, then some derisking strategies may not be right for you, as you will want to keep your pension pot invested in assets with long-term growth potential. Many employees have company pensions with default derisking strategies in place. But these aren’t based on individual circumstances and it’s important to assess whether they are right for you. For example, if you don’t need to access pension investments in the early years of retirement then a derisked pension fund might be inappropriate.

Meanwhile, people with defined benefit pension schemes must decide if they want to take a big lump sum initially and then receive a smaller pension income or whether they want to take a small initial lump sum and get a bigger pension income. This is a one-off decision with huge retirement implications.

In retirement

There are two categories of retirement income:

1. Secure pension income, from defined benefit (DB) pensions or annuities

2. Unsecured pension income, in the form of drawdown income from defined contribution (DC) pension pots.

A DB pension is one in which the income you receive is based on your salary level and the number of years you contributed to the scheme. The salary level could depend on your earnings at the time you left the company or organisation or when you retired. But it could also be based on your average salary with the employer.

A DC pension is one in which your retirement funds are dependent on how much you and your employer contributed and how these investments performed.

Before we consider these two categories, the first thing to do is find out if there are any older pension schemes you may have forgotten about. After all, it’s easy to overlook previous pensions in today’s transitory jobs market.

Secure pension income

A secure income can provide income for life with no investment risk. As such, it offers peace of mind but it has little investment flexibility.

A starting point would be to work out whether your income will cover your outgoings now and in the future. You also need to establish if your workplace pensions or annuities offer returns linked to a market index or against inflation. Some retirement income products may only offer a limited annual increase, which may leave you short in the current high inflation world.

In some cases, a large proportion of the retirement income for a married couple or civil partnership may come from just one of the spouses. If this spouse passes away, then the other spouse could face a retirement shortfall. In this case, you need to find out what the dependent partner would receive on the death of the partner with the larger pension. They might get 50 percent of the pension, but it could be two-thirds. Similarly, if the couple bought an annuity, then you need to know the impact on each spouse if the other spouse passes away.

If your retirement income does meet your outgoings, then you may want to plan for future events, such as passing on wealth. And you will probably want to organise any other investments you might have so they are held tax efficiently.

If your income does not cover your outgoings, then you could break your outgoings down into two categories: essential and discretionary. You could then work out if, by reducing your discretionary spending, you could ensure outgoings do not exceed income. If your outgoings do still exceed your income, then you need to consider how you might top the income up. Non-pension investments and savings may then come into play.

As with the earlier life stages, you may benefit from utilising ISA allowances, the annual dividend allowance and the annual savings allowance. You could also consider onshore and offshore bonds. Should you still face a shortfall, then you may need to consider alternatives such as reducing your discretionary outgoings, downsizing your property or obtaining equity release from your home.

Unsecured pension income

The unsecured approach offers investment flexibility, including the ability to pass on wealth, but it comes with investment risk and requires regular reviews.

When it comes to managing a pension pot, you need to decide what income you require and when you might receive it. A key element for most of us is the state pension. If you don’t expect to receive the full state pension, then you may be able to make voluntary National Insurance contributions to ensure you do receive the full amount. If you’ve got gaps in National Insurance payments between 2006 and 2016, then you have until 31 July 2023 to decide if you want to top up. After 31 July 2023, you will only be able to top up any missing national insurance contributions for the 2017 to 2023 tax years.

There are two phases in retirement:

• Active retirement, which will vary depending on individual circumstances

• Passive retirement, typically after the age of 75.

These phases vary according to individual circumstances, which includes factors such as your state of health and lifestyle.

Spending on luxuries typically reduces in the passive phase: you may, for example, do less travelling. But spending on essentials generally goes up in the passive phase. These might, for example, include paying for people to do the cleaning and gardening. You may also want to prepare for the possibility of you or your partner needing long-term care.

It’s important to be realistic with retirement costing. Try to include all possible future costs, such as changing a car every few years. Try also to reach an early decision about the age when you will switch from active to passive retirement. And review all this actively and regularly.

It sounds counterintuitive, but someone in drawdown with a prospective inheritance tax liability should consider making their pension the last pot of money to draw on (assuming they are able to take income from other assets). This is because a pension pot is outside the estate for inheritance tax purposes, meaning that a larger estate could potentially be left to beneficiaries. If someone inherits a pension pot then, if the person died before 75, they will receive it entirely tax free. But if the person dies after the age 75, then any withdrawals will be liable for income tax.

A solution that blends both secured and unsecured income may be the best solution for some people. This approach could make use of pensions and non-pension investments in order to make efficient use of available tax allowances.

Conclusion

As this article shows, retirement planning changes significantly as we move through our key life stages. Retirement planning is also dependent on our own unique circumstances and we believe a financial adviser is well placed to help create a retirement plan that matches your particular requirements. At SPW, we advocate taking regular financial advice reviews to help you on your retirement journey.