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Should I drain our pension pots one by one?

Our experts explore ways this reader can generate a sustainable income of £50k a year
Should I drain our pension pots one by one?

Joanna is age 54 and earns £90,000 a year before tax, and her husband is 72 and self-employed. Their joint income is £170,000 a year, including her husband's state pension of £9,700 and index-linked pension of £14,000 a year. They are higher-rate taxpayers. Their home is worth around £850,000 and has two mortgages on it. 

Reader Portfolio
Joanna and her husband 54 and 72
Description

Sipps and Isas invested in funds and shares, final-salary pension, residential property, cash

Objectives

£50,000 a year in retirement, supplement pensions income, pay off mortgages, part time work/early retirement

Portfolio type
Managing pension drawdown

"I want my husband to have the option of retiring next year,” says Joanna. “And although it makes sense for me to work for at least two to three more years, I don’t want to continue in my current role for much longer. I’d like a better work/life balance, and my husband and I would like to spend more time travelling, relaxing and enjoying life while our health allows. So I will ask my employer if a part-time option is available from next summer.

"We will need £50,000 a year after tax to maintain our lifestyle. If my husband retires next year, his index-linked pension income will pay out £24,000 a year before tax. He could draw up to £26,000 a year from his self-invested personal pensions (Sipps), but doesn't want to take more or he will have to pay higher-rate income tax on it.

"After he has paid tax, that would leave us £7,500 short of our desired income of £50,000 a year. But if I continue to work my income will more than cover the shortfall.

"If we both retire or go part-time next year we will start to run down my husband’s professionally managed Sipp, which is worth £110,000 so cover four years. We have taken the tax-free cash entitlement from this and are leaving it to grow until he is retired and a basic-rate taxpayer.

"When that pot is exhausted we will draw from his other Sipp, which I manage, is worth £240,000 and should cover six years' income.

"I want to leave my pensions invested until I am age 60 or older, when I will first take a final-salary pension. This should initially pay £12,000 a year and an £80,000 lump sum.

"However, the former employer with which I have this final-salary pension is in financial difficulty. If the pension scheme has to be bailed out 90 per cent of my pension will be protected. But if I am already in drawdown, 100 per cent of my pension will be protected. If I take the pension at age 55 the lump sum will only be worth £60,000 and only pay out £9,000 a year. So I think it is better if I don't draw it until I am 60.

"My Sipp, which I manage, is worth £460,000, and my own and my employer's contribution to it amounts to £1,000 a month. I don’t think that I will need to draw from it for at least 10 years. But should I draw from my individual savings accounts (Isas) before my pensions? I had thought to take the tax-free cash entitlement from pensions first.

"We plan to take my husband’s remaining available Sipp lump sum of £60,000 in the next few weeks to help pay for some building work on our home which is likely to cost up to £100,000.

"I could make overpayments on the mortgage, top up my pensions or contribute to my husband’s Isa this tax year. I think topping up pensions is the best option because as a higher-rate taxpayer I get 40 per cent tax relief. But should I top up my husband’s Sipp first? 

"If my husband dies before me, I believe I will lose his state pension plus half his personal pension.

"The main mortgage on our home will reduce to £170,000 by August 2020 when the current five-year deal ends. In June 2020 I could take the cash entitlement from my Sipp, which is worth £115,000 to pay part of that down, and pay off the rest in August 2020 using other savings. 

"The second mortgage should reduce to £40,000 by May 2023 when the current five-year deal ends. We are thinking of making overpayments on this to reduce our monthly outgoings and pay it off as soon as possible. But as the repayments are only £1,000 a month and the interest rate is 1.99 per cent, it might be better to invest excess money elsewhere.

"We have very little instant-access cash – just £15,000 in an online savings account that pays 1.5 per cent a year. So I would like to build up cash worth around two years of our income, outside Isas, from next summer. 

"I have been investing for more than 30 years and my attitude to risk has always been medium to high. But I have started to make more conservative investment choices, and over the past few months have moved a large amount of our portfolios into funds that I think will reduce risk and costs, such as Baillie Gifford Managed (GB0006010168). I am looking to preserve the capital value of my pension before I take my tax-free lump sum, but am not sure what funds to invest in to achieve this. I have a limited understanding of bonds and have read that they are not a good place to allocate to at the moment.  

"After I have taken my tax-free cash entitlement from my pension in June 2020 and reinvested the balance, my risk tolerance for this account will be higher as I plan to leave it invested for at least another 10 years. I will be able to tolerate a fall in the value of this account of between 20 per cent and 25 per cent, and want it invested in funds that will generate growth over 10 years or more.

"I don't want my husband’s larger Sipp, which I manage, to fall more than 10 to 15 per cent in value over the next five years, or his professionally managed Sipp to fall more than 5 to 10 per cent as we may start to draw from this next year.

"I want to treat our various accounts as different pots with different time horizons, with most of mine positioned for growth over the longer term.

"I only invest in what I understand, and am more familiar with active open-ended funds than investment trusts and passive funds, although I have started to consider the latter because they are cheaper."

 

Joanna and her husband's portfolio

HoldingValue (£)  % of the portfolio
Baillie Gifford Managed (GB0006010168)234,22623.9
Baillie Gifford Global Discovery (GB0006059330)57,8705.91
Vanguard LifeStrategy 60% Equity (GB00B3TYHH97)66,4396.78
Baillie Gifford UK Equity Alpha (GB0005858195)40,1954.1
Baillie Gifford American (GB0006061963)54,8615.6
Legal & General Global Technology Index (GB00B0CNH163)54,2155.53
LF Blue Whale Growth (GB00BD6PG563) 44,4964.54
Basket of cannabis shares* 43,1544.4
Lindsell Train Global Equity (IE00BJSPMJ28)40,4014.12
Fevertree Drinks (FEVR)37,1183.79
Scottish Mortgage Investment Trust (SMT)23,9292.44
Hargreaves Lansdown (HL.)22,7642.32
Marlborough Special Situations (GB00B907GH23)20,7672.12
Fundsmith Equity (GB00B41YBW71)17,8091.82
Allianz Technology Trust (ATT)15,0001.53
Fidelity Asian Dividend (GB00B8W5LX86)14,0201.43
Janus Henderson Global Equity (GB00B68SFJ13)12,8371.31
Fidelity Global Special Situations (GB00B8HT7153)12,6591.29
Legg Mason IF Japan Equity (GB00B8JYLC77)12,1641.24
iShares Pacific ex Japan Equity Index (GB00BJL5C004)11,6071.18
First State Global Listed Infrastructure (GB00B7DYMW38) 11,3891.16
Artemis Income (GB00B2PLJH12)11,2921.15
Barings Europe Select Trust (GB00B7NB1W76)10,9861.12
BNY Mellon Global Income (GB00B7S9KM94) 10,5471.08
Smith & Williamson Artificial Intelligence (IE00BYPF3314)10,0001.02
AXA Framlington Health (GB00B6WZJX05)9,6270.98
M&G Global Dividend (GB00B39R2Q25) 9,0520.92
Invesco Global Equity (GB00B8N45Y36) 8,1580.83
Invesco UK Strategic Income (GB00BJ04KY80)8,0580.82
First State Global Listed Infrastructure (GB00B24HK556)6,2860.64
Investec UK Smaller Companies (GB00B5NR9271) 5,5820.57
iShares Emerging Markets Equity Index (GB00BJL5BW59) 5,3220.54
Greggs (GRG)5,2670.54
Mondi (MNDI)5,2120.53
Liontrust UK Smaller Companies (GB00B8HWPP49)4,8120.49
Baillie Gifford Japanese Income Growth (GB00BYZJQH88)3,5170.36
Baillie Gifford Japanese Smaller Companies (GB0006014921)3,3530.34
Cash15,0001.53
Total979,991 
*Aphria, Aurora Cannabis, Canopy Growth, Davidstea, New Age

 

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

 

Chris Dillow, Investors Chronicle's economist, says:

You are probably right to delay taking benefits from your final-salary pension. If you receive this while still working you’ll pay higher-rate tax on it, which would be likely to reduce your pension benefits more than if you get a reduced amount following a bail-out. 

If you have spare cash and are a higher-rate taxpayer, topping up your pension is probably the best option. Pension rules might change in future, restricting tax relief or cutting the lifetime allowance, but also having an Isa mitigates this risk.

Running your pension pots with a longer-term investment horizon and your husband's with a shorter-term investment horizon may not be a good idea. Whether you should do this comes down to whether equities are safer over the long run than the short run. History tells us this has been the case with the FTSE All-Share and S&P 500 indices because these have recovered after every fall. And the FTSE All-Share's dividend yield has been a good indicator of what its longer-term returns will be. This suggests that longer-term investors should load up on equities, and shorter-term investors hold a mix of equities and safer assets such as cash.

But history also tells us that markets can suffer huge long-term falls as a result of political events or overvaluation. Japanese equities in 1987 and Russian equities in 1915 were good short-term investments, but terrible over the longer term. This is even more the case with individual stocks. In the short run, companies are not in great danger of failing, but in the long run collapse is almost inevitable. Because of this, whole sectors can sometimes suffer huge losses, for example, technology stocks lost 95 per cent between 2000 and 2003.

I would manage risk in the same way across all your Sipps by following the 10-month or 200-day average rule. You buy or hold investments when their prices are above this average, and sell them when they are below it. To avoid buying and selling too much, allow a 2 to 3 per cent cushion either side. This rule protects you from the risk of long bear markets and allows you to participate in bull markets. Following it means you will not buy into dips and miss out on short-term rallies, but evidence suggests that this is a small price to pay for avoiding the worst bear markets.

You should follow this rule when investing in emerging markets and tech stocks. These are not plays on future growth but rather plays on sentiment, which comes in waves that the 10-month rule helps you ride.

I’m puzzled by your claim that you are more familiar with active than passive funds. A passive fund is, in effect, a low-cost fund of funds. A FTSE All-Share tracker, for example, is just the weighted average of every investors’ holding in UK equities. If you don’t know which fund or stock to back this should be your default option.

 

Kay Ingram, director of public policy at LEBC Group, says:

You want a net income of £50,000 a year in today’s terms after you have paid off your mortgages. Your guaranteed annual income will be as follows:

 

 

Husband's annual gross income (£)

Joanna's annual gross income (£)

State pension

9,700

8,800 (from 2032)

Index- linked private pension

14,000

12,000 (from 2025)

Total

23,700

20,800

Net of tax*

21,460

19,140

*Based on 2019-20 allowances and rates as per UK income tax (excluding Scotland)

 

So you have a shortfall in the guaranteed annual income you require of £28,540 between 2020 and 2025, £16,540 between 2025 and 2032, and £9,400 from 2032 onwards.

But your goal of working less appears achievable, even without touching your pensions or Isas. On your current earnings levels, you could afford to work two days a week pro-rata and cover your income needs. If you did this until age 60, your pensions and Isas could then cover the annual shortfall.

While you are both alive the annual income shortfall of £16,540 between 2025 and 2032, and £9,400 thereafter, would require your remaining pensions and Isas to grow with inflation and produce an income yield of 2.12 per cent until 2032 and 1.2 per cent thereafter. These are modest targets and would require no more than a medium risk asset allocation, with sustained income and growth being the key drivers. Any additional income could be used for discretionary spending and adjusted according to the overall yield.

Taking this approach and paying the tax-free element of Joanna’s Sipp into the Isas over a few years would enable you to build up to £270,000 in Isas and retain £635,000 in pensions, from which you could take income at the rate required to meet the income shortfall. Doing this is likely to be more tax efficient than draining your husband’s pension early and then emptying yours, which could also result in an income shortfall in later life.

Investing in a cash flow plan prepared by a financial planner could help you ensure that the level of income you need remains sustainable and to determine the level of investment risk you need to take. It also provides a framework via which to manage setbacks such as a market crash, changes in taxation and income needs, ill health, or bereavement, all of which could disrupt your plans.

You can inherit each other’s Isa value as an additional allowance so that the funds remain in a tax-efficient environment. Your pension drawdown monies can also remain invested in a largely tax-free environment. Private pension plans inherited from someone who dies before age 75 pay out income, tax-free, to the beneficiary. If a pension plan owner dies after age 75, the recipient pays income tax at his or her income tax rate when income is drawn. So raiding your husband’s pension to pay down the mortgage early and stripping out funds quickly is not tax efficient.

Paying off your mortgage early while interest rates are low may be less beneficial than paying into pensions while you are getting 40 per cent tax relief. You could invest up to £13,000 and your husband up to £30,000 a year in pensions, which would qualify for 40 per cent tax relief. You could collectively invest £43,000 more in your pension funds for a net cost of £25,800. Neither of you are in danger of breaching the lifetime allowance, which is currently £1,055,000, and rises in line with consumer price index (CPI) inflation on an annual basis.

Consider converting to a lifetime mortgage after Joanna is over age 55. This does not require any interest or capital repayment until you die, or for you to sell the property or move into residential care. Some plans offer the option of paying off some capital or interest, and can also be transferred to another property. Mortgage lenders who are members of the Equity Release Council offer a no negative equity guarantee so that the borrower never loses their home. If you do not plan to leave an inheritance after you die it is a way to make your assets cover the whole of your lives. This would mean that you could leave most of your Isas and pensions invested for income, which will be important if you survive your husband by a lengthy period.

Alternatively, you could convert some of the mortgages to an interest-only payment basis, which would reduce your day-to-day outgoings, making part-time work affordable. You could pay off the mortgages when Joanna receives her tax-free lump sum at age 60.

If your husband dies before you, you should get some of his earnings-related state pension as he reached state pension age before 2016. Based on the figures you have given, this would be worth about £1,500 a year.

You expect to inherit 50 per cent of your husband’s index-linked private pension. But this may not be the case if the pension is paid from an occupational scheme. Some schemes reduce the pensions paid to a younger spouse, where the age difference is 10 years or more, so check the scheme rules. When planning for a lifetime income, check the facts rather than relying on assumptions.

You should check your state pension entitlement estimate as the figure you have given is the maximum payable under the new flat-rate scheme. But you may not get this due to the complex interaction with the pre-2016 scheme. And as a member of an occupational pension scheme, you may have contracted-out service which results in a reduction. You are a high earner so may have an additional state earnings-related pension, so will get more than £168.60 a week. You should request a new estimate from the government website as many estimates issued since the 2016 changes are incorrect.

If you survive your husband you will lose around £15,200 of your joint income, or £13,408 after tax, but inherit your husband’s Isa and pension funds. You would need to reassess your income needs and the rate of income required from these funds to top up your guaranteed income. Withdrawing only the income you need from these funds, rather than stripping out more, is likely to provide a more sustainable income. Withdrawals surplus to income requirements are tax inefficient, as pension and Isa wrappers allow invested funds to grow tax efficiently.

Your former employer’s scheme is protected by the Pension Protection Fund (PPF). If you are under retirement age at the time a scheme enters the PPF, 90 per cent of the pension is guaranteed, so up to £26,578 a year at age 54, payable from age 60. Benefits accrued since 1997 rise in line with CPI up to 2.5 per cent, but those accrued before then do not increase. Taking an early retirement scheme pension will not improve this. You could transfer it out to your personal pension but would no longer have any guaranteed pension and, if the final-salary scheme is in difficulty, it may not offer a full transfer value. You would need to receive regulated financial advice on this.

If you do a transfer, you would not be obliged to draw the benefits immediately. Although 55 is the minimum age at which pensions can be drawn it is not the optimum age. Sustainability of long-term income usually requires leaving them invested for longer. If your pension is well below the protected amount limit, staying in the scheme until age 60 is the lower-risk option.

 

Shelley McCarthy, chartered financial planner at Informed Choice, says:

Your husband is nearing age 75, the point at which the tax treatment of  Sipp death benefits changes, so it makes sense to take the remaining tax-free cash from his pension to fund your building work.

If you repay the mortgages with your Isas and tax-free cash from your final-salary pension, and use £60,000 of tax-free cash plus earnings to cover your building work, you will have assets of £750,000 within your Sipps. You will need to generate around £23,000 a year from your assets to meet your target of £50,000 net income a year, which equates to just over 3 per cent a year. We would suggest that you have a cash flow forecast done to determine the probability that your plan will succeed. This forecast would stress test these assumptions, and factor in events such as a stock market fall or reduced growth rates.

Regarding your final-salary pension, it is not clear whether the figures you have quoted include exchanging part of the income for additional tax-free cash. If the latter is the case, as income is your highest priority that may not be the best option. Whether you take benefits early partly comes down to whether you retire or work part-time next year, as well as the risk of a potential reduction if your scheme goes into the PPF. You need to calculate the extra income you would receive between ages 55 and 60, and how long it would take to recoup this if you didn't take benefits until age 60.

Regarding how much of your lifetime allowance you have used up, your annual pension will be multiplied by 20 and the tax-free lump sum will be added to this figure. At age 60 this would give a figure of £320,000, so it looks as though you could fund your pensions further. You are a higher-rate taxpayer so will receive 40 per cent on contributions. As you are likely to be a basic-rate taxpayer in retirement, prioritising pension contributions over Isa contributions is likely to be beneficial.

Your husband is a higher-rate taxpayer, under age 75 and doesn't appear to have triggered the money-purchase annual allowance, so he could consider topping up his pension and receiving higher-rate tax relief. Whether you top up your or your husband’s pension first depends on ensuring that you get higher-rate tax relief, whether you retire or work part-time, and when you are likely to draw benefits from the pensions. It is likely that you could continue to monitor the value of your pension and crystallise, if necessary, to ensure [that it remains below] the lifetime allowance limit. 

Given uncertainty in the markets I would start building a cash buffer immediately even if this involves using funds within pensions or Isas. Cash can be a drag on performance, but given the level of debt you need to repay in the relatively short term and imminent life changes, I would increase the cash and safety within your portfolio.

As you have no financial dependents and mitigating inheritance tax is not a high priority, there is no great disadvantage in drawing from your pensions before your Isas. But there is an argument for drawing from your Isas first, as the amount of your pensions' tax-free entitlement could increase over time if your pensions continue to grow.

Whether you overpay the second part of the mortgage comes down to risk and whether you think you could achieve higher returns by investing the money instead over the same period. As you are both looking for a better work/life balance and repaying debt gives peace of mind, I would consider repaying it as soon as possible.

Many investors overcomplicate their investments, but keeping things simple and only investing in things you understand makes sense. But while your portfolio is relatively well diversified across equities, you do not have much exposure to other assets such as bonds, commercial property or cash. Review your overall asset allocation twice a year and consider having a ‘punt pot’ of some of the investments in which you are interested but could afford to totally lose.