How do we plug our retirement income shortfall?

Jacob is 67 and his wife is 65. The two of them currently receive a gross annual income of just under £70,000 comprising various pensions, with Jacob’s wife’s state pension to commence next year. They also have self-invested personal pensions (Sipps) worth around £930,000 between them, a large amount of cash, some Isa holdings and other assets such as premium bonds.

Jacob notes that they should not need to draw on any of the funds for the next five years. “Our income is currently more than sufficient to meet our routine expenditure and at present we have no plans for major capital purchases,” he says. But the couple will need to generate a substantial level of additional income in five years, when a partnership annuity accounting for £44,000 of their current income ceases.

“Once the partnership annuity ceases in five years our income will fall substantially,” he explains. “We would then like to be able to draw £30,000 to £35,000 a year to supplement our state pensions and my wife’s defined benefit pension. We would do this from our non-Sipp funds initially, a large proportion of which are currently held in cash.

“With inflation at a 40-year high plus volatile markets we are trying to determine where best to invest that cash to provide growth. We appreciate that to attain our desired income we may also need to draw down on capital over time if we choose not to touch the pension funds.”

Jacob and his wife have two children, both of whom are financially independent. They gifted sums to each child a year ago to help them with property purchases. However, Jacob adds: “I would like to maintain the value of the pension holdings as far as possible, care costs, etc, permitting, to leave some legacy for our children/grandchildren. I have a serious health condition which is likely to limit my longevity.”

Jacob bought a few shares over the years but started investing in earnest once funds were transferred to his personal Sipp on retirement. Of his investment approach he notes: “I have always been fairly cautious but appreciate I may now need to be a little less so in order to achieve our goals.

“I tolerate more risk in my Sipp and my preferred investment vehicles are investment trusts to provide a geographical and sector spread. I also purchase UK shares and tend to focus on companies allied to satisfying consumer’s basic needs. The Quilter SIS holdings in my Sipp were a portfolio selected by my former financial adviser.”

His most recent transactions were investments into Fidelity Global Enhanced Income (GB00BD1NLL62), Fidelity European Trust (FEV) and Reckitt Benckiser (RKT). When it comes to future investments, Jacob has considered buying a small number of low-cast tracker funds such as the Vanguard LifeStrategy products.

The couple's home is worth approximately £600,000, and they have no mortgage or other debt.

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Matt O’Hara, wealth management consultant at Mattioli Woods, says:

You have done a good job of diversifying your asset base, utilising your Isa allowances and building good pension provisions.

Looking at your pensions, your wife is unlikely to breach the lifetime allowance (LTA), but you are in danger of breaching the current £1,073,100 limit. Provided you have not contributed since 6 April 2016, it may be worth looking at putting some transitional protection in place to boost your LTA to £1.25mn to mitigate the possibility of a tax charge being applicable if the value breached the LTA limit.

Your pensions can be passed directly to your children/grandchildren upon your deaths and should pass tax-free if you died pre-age 75 (unless there is an LTA charge) but would be taxable at your beneficiaries’ marginal rate of income tax if you died post-age 75. They also fall outside of your estate which is liable to inheritance tax (IHT), so I agree that you do not need to draw on them to supplement your income when the annuity income ceases, given your substantial cash savings. Your higher-risk investment strategy is also suitable as you have a long-term time horizon for investing given the likelihood that you will not need to draw on the Sipps.

Turning attention back to your personal estate, you have a lot of cash which you could utilise to bridge the income shortfall in five years’ time. However, it would be unwise to leave all of this in cash until you need to draw on this as inflation will erode its true value, so looking at short-term investment options for some of the cash seems a good idea. I suggest adopting a more cautious/balanced risk approach than elsewhere, but with more risk than cash, given your reliance on these funds over the medium term. Diversification is also key, and as interest rates rise, a traditional 60/40 equity and bond portfolio probably is not right – look to income-generative investments which provide a steady if not extravagant return to supplement your income.

If you pass your main residence onto direct descendants, you can benefit from the residence nil rate band (RNRB) of £175,000 each (provided your total estate is valued below £2mn), so added to your nil rate bands of £325,000 each (assuming your previous gifts have not used any of this already), this means up to £1mn of your estate might not be liable for IHT, but anything above that could be subject to IHT at 40 per cent. If the value of your total estate is above £2mn, the RNRB reduces by £1 for every £2 above this. I would, therefore, not be overly concerned about drawing down on your capital as you have headroom here.

As you approach later life and given your deteriorating health, it would be worth involving your wife and children in future planning so that they are well versed and understand the ins and outs of your finances.

Peter Cranwell, independent financial adviser at Purely Pensions, says:

As your health condition could impact your longevity, this will directly inform your financial strategy. An immediate consideration should be to make sure wills are up to date and a power of attorney is put in place, if not already there.

With regards to current financial arrangements, there needs to be a structured plan to help make up the substantial fall in income in five years’ time. Initially, in order to be tax-efficient, we would look to draw down some of the cash in your Isa to make up this replacement income. However, you may also choose to invest some of that cash between now and then – this is something I would certainly recommend.

Some financial advisers may suggest keeping a year’s worth of cash available. It is certainly advisable to have an emergency fund in place, but I would suggest thatthis should total about three to six months’ worth of expenses.

Currently, there are some interesting opportunities in structured products and deposits. Structured deposit and structured investment products offer exposure to stock market growth with the potential to either earn a return or have the capital returned.

You can afford to put your money away for a few years and even have a ‘kick out’ plan for five or even six years. This would offer diversification of your savings, presenting a lower risk and offering a known return. 

There is, of course, always a risk, but this option would undoubtedly provide a better solution compared with leaving a chunk of your funds in cash.

You could explore how much it would cost to have £30,000 guaranteed income for the next 10 years. This, in addition to the state pension kicking in, should cover the anticipated income shortfall. 

This could be achieved with a purchased life annuity, either as a standalone product or within a pension plan such as Canada Life’s Retirement Account. The benefit of this product (Canada Life Retirement Account) is that your wife can turn off the payments if she doesn’t need them, and the money can stay in the Sipp until needed.

Your use of investment trusts is prudent, as these are very tax-efficient vehicles. Another consideration could therefore be to buy more investment trusts that give you access to a broader range of asset classes. These can be particularly effective for creating an income stream from dividends: a particular benefit of this is that they can withhold up to 15 per cent of dividends each year, which can then be used to increase the dividend if the following year is more volatile.

If IHT is a concern, you may also want to consider equity release to free up some of the value of your property. This is an effective way of potentially reducing the value of the estate, and, with no mortgage on the property currently, it could also potentially help towards health costs.

Finally, if you have been managing the finances for the majority of the time, it could be difficult for your wife to pick things up in your place. It is best to get these options in place sooner rather than later, to ensure your wife will have enough to live on, should your health condition worsen.