The Bridge to Financial Independence

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).

Mr Z!  

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).

Mr Z

[Hope you are spending the weekend generally ignoring the build up the Black Friday, like a good Thrift Warrior]

19 thoughts on “The Bridge to Financial Independence

  1. John B

    The two added complications are the NI advantages of salary sacrifice that boost the advantages of pensions over ISAs, and inheritance, which for many will provide a huge injection of cash in the 55-65 age range. Of course the latter is extremely hard to model, and often difficult to talk about.

    I've tested my models against access ages up to 65, and while they are robust to that, its probably the key reason I keep working, to bolster the numbers, as looking for an IT job at 60 after being out of the market for 10 years, I don't think so….

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  2. ermine

    Just to toss more complication into the mix, the idea of running your ISA flat before the pension only makes sense if your pension is below the personal allowance (whatever that may be in 20 years' time). Else you will want some sort of mix – there's no point saving 20% tax into a pension to be taxed 20% on it. Whereas if you keep the pension to your pay over the 40% tax threshold and divert the rest into ISAs (assuming you have enough ISA allowance available to you) you can draw from the ISA tax-free and minimise the tax on the pension.

    However, this assumes an expectation of steady employment – otherwise pensions derisk some of the risk of creditors and the DWP chasing your wealth in an employment suckout. Likewise if you get employer match this improves the case for the pension a bit, though it's still nicer to get that on your 40% taxed pay 🙂

    Given the HRT threshold is about 43k (=net 32k) and the ISA threshold is 15k, maxing the ISA and then pensioning the 40% pay assumes you can live on 17k p.a. which many people living in the southeast consider borderline penury.

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  3. M from There's Value

    My calculations are not as good as yours by any means. They were literally scribbled on the edge of a letter from my SIPP provider. Basically, I worked out that under my current circumstances, I should put the monthly minimum into the SIPP and shove anything else into my NISA. I currently pay almost 0 in tax, so I only really use the SIPP because there is a small tax topup allowance for unemployed/housewives/people with unearned income/children/etc. FI is due in 16.5 years and husband's pensions kick in from 20.5 years, mine in 22.5… I think we're covered.

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  4. weenie

    Great analysis there, Mr Z. I recently had a look at my own calculations and have come to the conclusion that my pension/ISA split will be 40/60 too. It will hurt a little as the more I save in my ISA, the less tax relief I get during my accumulation phase, but for piece of mind and getting my hands on the cash before retirement age, I think I'm doing the right thing.

    Don't forget that if you max out your ISA contributions, you will still be able to receive up to £5k of dividends tax free so worth considering investing in taxable accounts too. You could have around £125k worth of ETFs in a taxable account, churning out £5k dividends (at say 4% yield) and that would be tax free. Of course, if you needed to sell, CGT may be a problem if you go over the £11k threshold.

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  5. Mr Zombie

    Hi John,

    The inheritance benefits of a pension could potentially be huge. Along with the salary sacrifice you mention makes the pension even more attractive.

    It's just the uncertainty around access that is going to make that one more year seem more attractive. Of course, it could change the other way and access could become easier, seems unlikely though…

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  6. Mr Zombie

    Pretty much along my lines of thinking. I'll take the Pension up to the employers contribution stops. Above this piling into a pension still looks favourable up to the point HRT relief goes.

    "pensions derisk some of the risk of creditors and the DWP chasing your wealth in an employment suckout" – hadn't considered this, good point. Another positive for the Pension.

    Perhaps I just dread the admin of having taxable investments and needing to get involved in tax lost harvesting and other such stuff.

    £17k would do me fine 🙂

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  7. Mr Zombie

    Good work on paying nearly 0 in tax 🙂

    Sounds like you've considered it and got it covered. Wouldn't be great to have enough wealth to gain FI, but not have the access to it.

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  8. Mr Zombie

    Yeah, I think the 20% relief on the pension can be a hindrance, as it feels better than the tax relief on offer from as ISA.

    That is a great point around the dividends, something like the Vanguard All-World High Yield ETF would do nicely outside an ISA 🙂

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  9. John B

    I was thinking of getting inheritances in your 50's. I think that excluding pension pots from IHT is foolish, and was surprised the government introduced it. I expect the decision to be reversed some time.

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  10. John B

    The dividends can be added to your personal allowance, so £15k of dividends can be tax free if you are not earning. So about £500k of taxable funds at 3% dividends Note that while bed and breakfasting to the same fund to defuse CGT is not allowed, HMRC treat each index tracker as different, so you can cycle through Vanguard/Blackrock/Fidelity FTSE trackers without leaving the market for a month. If you assume 2% inflation and 2% fund growth over that, £500k generates £20k of CG a year, so its the bigger constraint on size than dividends at present.

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  11. London Rob

    Hi Mr Z,

    Great thinking there and interesting to see! The fact that the pension age keeps shifting, and lifetime allowance keeps getting reduced, I am naturally nervous about it! Having said that, my company puts in a match of up to 6% into a pension, so I default to 10% in, so 16% into my pension without thinking about it!
    I accept that this means I can't touch it, so if i want to retire before I am 57, I need to fund it some other way (and means a nice big pay rise when I get to 57!). Right now we are looking at maxing out both my and my other half's ISA allowance. After that, there are a few choices – either top up my pension more to make use of the tax relief (I need it.,…), once that is maxed, then it may either be into Premium Bonds as my cash reserve, a taxable account in both mine, and my other half's name, to generate income, and after that… well… I will tell you if I ever get there!

    Keep up the good writing!
    London Rob

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  12. John B

    I think so, "Bed&ISA" is a common term on the Internet, and they don't seem concerned about CGT. After all you realise the CG on the first transaction, and have dropped out of the CG system on the second, so if you sold again, you'd have no liability anyway.

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  13. Emma Plays with Fire

    Hey Mr Z. I'm hoping to declare FI at a similar stage to you, and concerned about being 57/62 and working the streets or selling organs while staring mournfully at my giant SIPP statement. I'm dumping all of my 40% income into the SIPP this year, but that will probably be the end of it depending on what the next budget has in store.

    One of the weapons I'm considering is a massive mortgage that I'd take out in my final year of work, ideally interest only that would be paid off when I was well into my pension years (to hedge against more government meddling). I'm still running the numbers but it's looking like a winner. I also wonder if there will be bridging loans for pension access available by the time we get there? Not banking on it, but it could be a good (fairly low risk) product for whatever banking sector is around by the time we get our hover cars.

    Thanks for the great article, good to know that someone else is thinking along the same lines.

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  14. Steve R

    I don't think it's optimal from a tax planning point of view, but given I feel a certain distrust over access to funds in my SIPP, my current strategy is to contribute just enough to my SIPP to allow me to hit a certain magic number by the time I take early retirement, with the rest going into ISAs after paying 40% tax in return for the extra freedom and security.

    The magic number is an amount of money which I expect to grow (without further contributions) so that by the time I'm allowed to access the SIPP, the funds in it will generate an annual income equal to the personal tax allowance. That would be enough for me to live on, given I expect to have paid my mortgage off before I retire. I hope my ISAs won't be down to zero by that point so will deliver some extra income, but that's a separate matter

    Assuming 5% growth rate and a 4% SWR, with n years until SIPP access is permitted, the magic number £x satisfies x*(1.05^n)*0.04=£10600, so if n=15 (which is probably about right for me), the magic number is about £125,000. If I feel like taking a punt on the continued existence of the 25% tax free lump sum, I could argue for contributing up to an extra 33% above the magic number (i.e. up to £170,000), so I could take the 25% lump sum and still have the magic number left. If the lump sum isn't an option, the extra cash would allow me to use a 3% SWR when I start drawing down the SIPP instead, so contributing the extra 33% is both optimistic and pessimistic at the same time. 🙂

    (Credit where it's due: I think I got this idea, or at least the kernel of it, from a comment on Monevator. There is some similarity with the approach in this MMM article: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/)

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  15. Mr Zombie

    Hi Rob,

    Exactly, it's hard to ignore the company match!

    A payrise at 57 is an awesome way to think about it! Sounds like your plan is pretty much like what Mrs Z and me are up to 🙂 I wish they would bring back inflation linked gov't bonds, that would be perfect!

    Thanks!

    MrZ

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  16. Mr Zombie

    Hello,

    Haha, selling organs is another option. See we'll be fine!

    I'll also take the tax relief while it's on offer, you never know though, the next budget might be amazing for us savers O_O

    Not a bad shout on the mortgage, I hadn't thought of that…although not sure how they classify between a mortgage and the more expensive equity release mortgages…?

    Good point about bridging loans, there may well be. Perhaps equity release mortgages have that covered, although they can be horrendously expensive. Could tide you over…

    Some great points there…. to the spreadsheets!

    MrZ

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  17. Mr Zombie

    Hi Steve R,

    It pays to be paranoid 🙂

    I'm taking the 40% relief at the moment, but if I get any more payrises above inflation or promotions that may stop, like you say, a 'freedom premium'.

    My target is also to live off my PA, I'm running slightly above it at the moment, but that includes my half of the mortgage payment.

    Some good maths there :). I have been looking at my Pension projections a fair bit recently, in a similar vein to your calculations, and it feels like I'm going to have a lot more than I 'need' locked away in my pension.

    Optimal from a tax perspective means leaving it as it is.

    Optimal from a 'pulling the trigger' perspective means taking the tax hit you mention.

    I did some quick sums for me and it looks like it would mean and 11 month reduction in the time to reach the same goal on the ISA (diverting funds from pension to ISA once that magic number is reached). But a reduction in the pension value of £138k ish at age 57. It's all about the trade off. Time to do some thinking 🙂

    Thanks for the thought provoking comment,

    MrZ

    Reply
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