Hey hey, it’s the weekend. What better way to spend it than musing over how we allocate our savings between the two tax efficient vehicles on offer, then ISA or the Pension.
If you are aiming to reach Financial Independence before you can get your hands on your pension, like I and many others are, then we need to consider what our options are for bridging the gap. The gap between declaring FI and drawing money out of a Defined Contribution pension. The Bridge to Financial Independence.
|A spooky bridge|
The ISA versus Pension war rages on
With ‘Pensions Freedom’ the lines are blurring between a personal pension and an ISA. A pension offers a huge boost for higher rate tax payers, employer contributions are like free money and you might get a tax free lump sum at the end (if it’s still on offer in the future). On the flip-side, you will pay income tax on withdrawals, over the personal allowance.
An ISA doesn’t have these perks, it simply shelters whatever is in there from tax. So no tax on the way out.
If you are in the higher tax bracket now and you won’t be when drawing down from your pension, the pension wins. This makes the pension appealing, indeed I upped my contributions with the proceeds of a recent payrise. From a pure tax efficiency point of view, the pension account wins a lot of the time.
Now, where did I put my cash
For those of us saving a sweet asses off for Financial Independence, we need to consider where we are putting our money (how much is going into an ISA or a Pension) not only for tax efficient planning (which is mighty exciting) but also as a matter of timing. When we will need access to our hoard?
If we want to gain our sweet freedom before regulation lets us get out mitts on a pension, then ploughing money only into a pension isn’t good. Tax efficiency sadly doesn’t pay the bills, or the tax, if you can’t access it.
I’ve missed the boat, but if you were really gunning for early retirement in your thirties, you are going to need access to more of your investments earlier on than someone retiring in their 50s or 60s.
At my current rate I should have enough to declare Financial Independence some time into my 40s. Let’s say 45. My pension wouldn’t be available for withdrawal until I was 58. That would leave me needing to fund myself, sans pension account, for 13 years until the keys to my pension were handed to me. Who needs a Ferrari, right?
There’s a balancing act here, careful, the bridge can be treacherous.
At one extreme you might not use a pension at all, pile money up to the ISA limit and then into normal investing accounts after this. You lose out on the tax benefits and employer matching of a pension scheme, but at least you can access the money when you need it.
At the other extreme you could chose to invest completely in a pension, taking full advantage of any tax relief, employers contribution and the potential for some tax free cash. You might feel pretty smug, but it causes a problem with access. Unless you want a heavy tax hit or are planning something untoward to get at your cash, you are going to have to wait.
A more balanced approach is best. I mean, who’d ignore employer Pension contributions?
Let’s go build a model
Suppose that the person in question is 45, has enough in savings and investments that they feel comfortable to set off the hand grenade of early retirement.
Let’s investigate this together, and run a simple model to approximate the split between assets in a pension account or an ISA.
I set up a very simple model, with the following assumptions;
– Starting investments of £625k, to provide £25k withdrawal a year at 4%, if the 4% rule is to be used as a basis.
– A real growth rate of 5% (i.e. after inflation)
The model projects the ISA to grow at 5% a year, but also fund the £25k a year withdrawals.
The model does projects the pension to grow at 5% a year from the ages of 45 to 58.
Using a quick goal seek, to leave the ISA completely exhausted at age 58 just in time to access our pension, we would need a split of 39.45% in the ISA and 60.55% in the Pension.
This would leave around £715k in our pension at 58 (the investment overall have grown because the growth rate is bigger than the withdrawal rate).
I hear your piercing shriek.
Withdrawal rates being fixed at 4% I can handle, but every one knows that investment returns will be volatile. Having them fixed at 5% makes no sense. It makes me nervous and I have to sit in the shed to calm down.
I haven’t got enough time to run stochastic simulations! Ohhh how I long for FI. But come back in from the garden, you are right. We would want some margin of safety to try and protect ourselves against this volatility. Let’s just try running a few scenarios through.
In fact, we only need to run the ISA through the model really, as this is the limiting factor here. It’s only if this is exhausted too early, before we can access our pension, that the ‘shit hits the fan’.
The graph below shows the projection of the ISA proportion of the portfolio, depending on various starting percentages of the total portfolio, all with the same growth rate of 5% and withdrawal of £25k a year. For example 90% represents a portfolio with 90% in an ISA and 10% in a Pension, which isn’t on the graph.
Everything is all good, until we try to run a portfolio that starts with only 30% of it’s value in an ISA. Sometime around the age of 54 we burnthrough the ISA and are left with the proposition of flipping burgers or working the streets for four years until we are allowed to access our Pension savings.
Starting with 40% in the ISA would be cutting it pretty fine, you’d only be left with about £6k in your ISA by the time you hit 58. Most of us would want more of a cushion than that.
With 50% we are left with £124k in the ISA, and onwards and upwards as we increase the proportion. 50% looks a lot safer to me.
In the background to all this, then Pension side of the portfolio would just continue to grow, uninterrupted by any withdrawal nonsense.
What’s the point?
You can’t conclude too much from the above, after all it assumes a deterministic growth rate (unvarying) and that your ISA and Pension are either invested exactly the same or at least perform exactly the same. Seems pretty unlikely.
And I’ve completely ignored any tax or dealing fees to keep things simple.
So again, what’s the point?
It shows me that if we are serious about ‘retiring’ before the social norm, then we need to put some thought into this fairly early on in the process.
For higher rate tax payers, the pension looks like the logical choice, there is a nice tax benefit up front, which could result in reaching your savings goal earlier. And there’s the thing, right there, we need to commit to giving up on potential tax benefits, in exchange for more flexibility in accessing our capital. We better be pretty serious about this whole thing then.
I think in the US they can access their equivalent accounts early…lucky sods.
A 65 year old spanner in the works
The age at which we can access our Pensions is far from fixed, even the tax relief on offer is subject to change from one government to the next.
Not only are we dealing with investment volatility, but also policy and regulation volatility at the same time. HOW IS A ZOMBIE SUPPOSED TO PLAN HIS ESCAPE WITH ALL THIS UNCERTAINTY?
RIT pointed towards an article earlier, which suggested that the age at which we can access our own pensions should be raised to 65. Because we are all so reckless we’d blow it all in a weekend of indulgence I guess.
Let’s have a look at how raising the age impacts our little experiment. Using the same model, but just extending the time frame from 58 to 65 there is quite the impact;
Now, from our starting portfolio of £625k, if you have anywhere below ~50% in your ISA you are in danger of exhausting it before you can access your pension.
To feel safe, from the results of this limited experiment, we are now looking at starting with 60% in your ISA and 40% in your Pension, or perhaps even 70% depending on your tolerance and ability to sleep well while the markets are freaking out.
The point being, the age that you can access your pension is a variable factor in your planning. Looking at it as a fixed number could lead to disappointment and furious anger. Remember, when planning these things, it pays to be a little bit paranoid.
Mr Zombie’s NetWorth currently is heavily weighted towards a Pension, but that’s through the distinct lack of any savings plan a couple of year ago rather than a plan. I’m currently saving more outside my Pension than I am in it, both into my ISA and a save-as-you-earn share option scheme. So this unbalance is slowly being addressed.
So what to do?
For me the simple thought experiment and model above brings home how important diversification is. And not just in terms of your asset allocation. But in every sense. TFS had an interesting point about income diversification. And diversification rings true here as well.
Diversify between the vehicles in which you hold your investments, not just to shelter them from tax rain, but because the regulations surrounding them can change in a heart beat. And this is rarely to be for the better.
Hell, there might even be a case for holding some of your portfolio outside either an ISA or a Pension. Sure, it will suffer tax (love that phrase, you have to suffer tax) and give you a bit of extra admin to do, but it’s a different kind of diversification. One to protect you from future regulation bombing runs on the Pensions and ISA shelters.
It does feel like there will come a time when my ISA contributions are maxed out and the choice remains, to save into a taxable account or to top up Pension contributions. At that point Mr Greedy will be eyeing up the tax efficiency of a Pension, I betcha.
As it stands, my contributions are weighted towards my ISA rather than my pension, around about 60/40. Over time my investments should tend towards this split. Given the above this seems sensible, although it’s through luck rather than any previous design.
I’d love to hear any thoughts you have on investing in ISAs or Pensions and the Bridge of Financial Independence in mind. (That’s right, round here when we are talking financial independence we use the words love and investing in the same sentence, deal with it).
[Hope you are spending the weekend generally ignoring the build up the Black Friday, like a good Thrift Warrior]