It is worth trying to define exactly what early retirement means since expectations vary. During the 1980’s, many large employers used their well-funded pension schemes to pay for laying off workers in their fifties by giving them early retirement.
In fact many of these people had no intention of retiring and used these generous packages to move into second careers. They did not retire at all until much later, in their sixties. Nowadays, what most people mean by early retirement planning is not stopping work altogether but having the financial freedom to change their lifestyles, free from children and a mortgage.
Create Sufficient Wealth to Sustain Your Lifestyle on Meager Earnings
First, it makes sense to try to estimate the amount of capital required. It pays to think of income and capital needs in real terms as it is easier to imagine an income need of, say, £35,000 per annum in today’s money than the actual income needed once inflation has been factored in. We can allow for the effect of inflation by ensuring that we only use real returns, i.e. over and above inflation. We then need to look at how much there currently is in long-term savings and investments, pension funds and property, etc. It pays to be brutally honest and take a little time for reflection at this point because it is easy to build a plan in which you either have little faith or end up being hopelessly optimistic or pessimistic. Allowing for a realistic return, we can estimate how much these will be worth at the target date and calculate the shortfall, working back to create a plan to meet it.
Once we know how much is needed, the fun starts. Investing for retirement is not just about putting money into a pension plan – it matters less how the money is held than that there is enough of it. Pension plans have the benefit of attracting income tax at the highest marginal rate and growth is free from additional UK taxes. At retirement, however, the balance remaining after the tax free cash of 25% has been withdrawn, must be used to provide an income and this is then taxed. For many, the tax rate in retirement will be much lower than their marginal rate whilst working. Even so, this can cause some problems with tax planning in retirement.
Most other ways of investing do not have the benefit of upfront tax relief, although Venture Capital Trusts offer some for braver investors, but they can offer access and lower tax in retirement.
Navigate Early Retirement Planning with Ease
The point at which you retire probably represents the single most complicated transition in personal finance. Nowadays, there is a bewildering range of choices for early retirement planning and the long term effects of a hasty decision can be catastrophic. The consequences of buying the wrong annuity or wrongly structuring drawdown (or unsecured) pension income can leave otherwise well thought out plans in tatters. Someone neglecting to inflation-proof their retirement income could find their pension halved in real terms over twenty years. A married person failing to ensure that the pension continues for their spouse on their death may be consigning them to a pretty bleak future in the event of an early death. Additionally, tax planning in retirement can be confusing for those used to PAYE.
Those reaching the age of 65 benefit from an increase in personal allowance, enabling more of their income to be taken tax free. This, however, is gradually withdrawn for those on higher incomes leading to some pensioners paying a high marginal rate of 33%. Having greater flexibility, allowing, for example, for the annual Capital Gains Tax Exemption to be used can give rise to considerable tax savings, which is a low- risk way of enhancing investment returns since few people enjoy paying tax.
With life expectancy for someone in their sixties stretching, perhaps thirty years ahead of them, buying an annuity on retirement is becoming less attractive to many. Thankfully, even those with pension schemes now have options. They may draw an income directly from the investment portfolio held within the pension, buy an annuity or use a combination of both.
Drawing an income from the pension, now called an Unsecured Pension, is not for the poorly organised. The investments held must be carefully selected to match expectations of income, allowing for inflation matching, and allow for preservation of capital. No one wants to run short of income too early so a sensible level of income should be taken. Also, thought should be given to rebalancing the portfolio to maintain its risk profile and whether that risk should be changed over time.
As with many planning exercises, it is imperative to allow sufficient time in advance for all options to be explored – it is never too early.