When can I retire? The question everyone asks
This week I’m answering a reader’s question, and it’s one that many of us ask ourselves as we get older: can I afford to retire, and if so what do I do next?
I was contacted by a gentleman, Arthur who wanted to understand his retirement options. Arthur was desperate to retire; frankly he’d had enough of the stresses of working – which is a shame as I like people to work in some form during retirement because work gives us a lot more than just an income; connection and relationships, mental stimulation, purpose to get up each morning. However, he’s been working for his company for over 30 years and is ready to stop.
First, let’s look at the key details:
- Age: 64
- Goal: To retire now
- Financial situation:
– No debts
– Grown-up kids
– Mortgage paid off
– Wife already retired
– Pensions funds totalling almost £500,000
– Savings from an inheritance of around £250,000
The first thing is to congratulate Arthur for arriving at retirement in such good financial shape. If you have debts, including a mortgage, then please try to do everything you can to pay them off before you retire. We’re living longer and longer, so we need to ensure we’ve got enough for our retirement and repaying our debt is a great step.
Arthur mentioned that he’s saved as much as he can towards his retirement after receiving a pay rise or bonus. He’s also on a good salary – £60,000 per year – so he’s paying a top rate of tax and has been sensible in putting his money into a pension to get the 40% tax relief on his contributions.
Arthur is in a good position to give up work. So how should he go about funding his retirement?
There are two ways to go:
1. Purchase an annuity
An annuity is where you hand over your pension fund to an insurance company, who would then give you a monthly income for the rest of your life. The level of that income is based on your age and health, but also what I refer to as ‘bells and whistles’. They include your:
- Desire for a level (fixed) income, or one which increases based on inflation
- Guaranteed periods – if you were to pass away on day one, you can guarantee your annuity to continue paying out for a period of time, say five or 10 years
- Spousal wishes – do you want an amount paying to your spouse in the event of your death?
You start with the highest level of annuity, and then each bell and whistle you add on reduces the amount you’ll receive each month. For example, if you choose that on death you want 100% of your annuity to continue to be paid to your spouse, you will receive a lower income than if they were to receive 50%, or nothing at all.
The benefit of an annuity is security. The income from an annuity is paid for the rest of your life, guaranteed. That security is very important to some people.
2. Drawdown on the funds
This involves taking a portion of your pension fund each year, and leaving the rest invested so it is still (hopefully) growing in value over time. If Arthur doesn’t draw down too aggressively, his pension fund should continue to grow.
There are two risks to this option:
- Market risk – if the markets fall in value, his pension fund could fall in value
- Drawing down too aggressively – taking too much capital out, leaving too little behind to cover him for the rest of his life
The benefit of the drawdown option is flexibility. Arthur can take different amounts from his pensions giving him a chunk of money that’s his to decide what to do with. And in the event of his death, he can leave his remaining funds to his children or spouse.
Both options would offer a tax-free payment of up to 25% of the fund value, and the income under both options is taxable at his highest marginal rate.
Which option is the right one?
There are pros and cons to both. Some people are not comfortable with the risk of not having an annuity, a secure and guaranteed flow of money; others want the flexibility to live life their way after they stop working.
There’s no right or wrong answer when it comes to how you should handle this decision: it’s a personal choice. While there have been plenty of headlines about the pension freedoms of drawing down since legislation changed in 2016, annuities are still highly relevant for a lot of people.
In Arthur’s case, he already has a nice sum of money (£250,000) in his savings that he can use for variable spending, like holidays, weddings, education for the grandkids and so on. Arthur and his wife are both quite naturally cautious, so for them and in their situation, an annuity was seen as the more suitable option.
Having decided that an annuity was the way forwards, Arthur had some questions to answer on how he wanted to structure it.
The first question is, how important it is that his wife receives an income in the event of his death? Does she have enough money in her own name to sustain her lifestyle, or is she reliant on his?
Because she’d retired earlier, she has some income herself, but not the same level of income as Arthur. We concluded that around 50% of his income should pass to his wife in the event of death, which will reduce his income but not by as much as if he chose to pass all of it on to her.
This was important and not difficult for them to answer.
Arthur opted for a guaranteed period of 10 years of payments even if he passed away, because this didn’t reduce his income by much – it was a relatively cheap option, and one he wanted to take.
Level income or inflation-linked?
This is a much tougher decision, and one that Arthur and his wife are still considering. Inflation is a risk to your capital, particularly as you get older: the cost of goods keeps rising, and your ability to earn extra money decreases.
That can make an annuity linked to inflation very attractive… but it’s also expensive. In Arthur’s case, the figures we had to consider were:
- An annuity linked to inflation (rising by RPI) would pay 2.6% of his pension value annually
- A fixed income annuity would pay 4.7% annually
That’s a big difference! On a £500,000 pension pot, Arthur’s annual income would be £13,000 for a linked annuity, compared to £23,500 in a level income arrangement.
Arthur’s in good health and actuarily, his life expectancy is 88 years old – meaning more than 20 years of annuity payments. RPI can vary considerably, so over two decades that’s a much bigger risk to the annuity provider; hence the cost of linking his income to it.
There is an option to split the annuity: take some of it level and some of it linked to inflation. In reality, our need for money generally decreases as we age; Arthur will be more active at 64 than he will be at 84, and will spend more.
Arthur could look at his basic living expenses, such as household bills, phones and so on, and buy an annuity linked to inflation to that amount, which should keep those covered each year; and then for his variable (spending) money, have a level annuity.
That gives him a guaranteed flow of money, as well as managing the effect of inflation. And don’t forget, on the side he still has his £250,000 savings, which gives him great flexibility.
Taking the right advice
As I’ve said, these decisions are incredibly personal to you and your circumstances. These days, we can Google many things we need to know; but this is one of those times when it’s really important to take the right advice.
Pay a professional, and get professional advice. Times of big financial decisions, such as inheritance, retirement and so on, are the right times to visit an expert, even if you don’t use one at other times.
For Arthur, with a little investment advice for his particular situation, he and his wife could actually be able to increase their income in retirement! Because he will be paying less tax on his investment returns and pensions, with a properly managed portfolio.
That might not be true for everyone, but it sure highlights the benefits of talking to someone.
Making the transition
My first question to Arthur was: what will you do instead if you retire? Arthur was working 12-hour days, and going from that to nothing is a big culture shock. After so long in work, we have set routines of getting up, going out and being challenged mentally. It’s important to transition, perhaps through doing some charity work or even going part-time to taper down the ‘shock’.
If retirement is right for you then great, go for it! But don’t underestimate the change that you’ll go through. Try to have a plan for retirement, to make sure you get the most of it.