The Retirement Newsletter: Bridging the pension gap
Issue Number: -88 — early retirement and bridging the pension gap
Welcome
Welcome to issue number -88. This week, I will look at early retirement and how you might be able to improve your retirement income while you wait for the State Pension (Social Security) to kick in.
Bridging the pension gap
OK, first off, I want to say that I am not a financial advisor. I am writing about what I have read over the years about money and preparing to retire. This is not financial advice. I am not advocating the drawdown pension.
I have written about levels of comfort in retirement many times:
And I have looked at the income you would need for an essential, a moderate, and a luxury retirement. As a reminder, these levels of retirement are:
Essential — not the most comfortable retirement, but you are retired. Your retirement will be limited by money, and you would need a net income of — single: £13,000 per year; married: £18,000 per year.
Moderate — much more comfortable than essential. You will not be overly limited by money. You can travel and do things you want to do. Net income needed would be —single: £19,000 per year; married: £26,000 per year.
Luxury — a retirement where money isn't a problem. You can afford some lovely holidays and have a very comfortable lifestyle. Net income required — single: £31,000 per year; married: £41,000 per year.
As I explained in Issue Number: -93 — When I’m 67!, the gross incomes required if you are under 67, with a National Insurance (NI) rate of 13.25%, an income tax rate of 20%, and the tax/NI threshold of £13,250 are:
Also, in Issue Number: -93 — When I’m 67! I explained that when you hit 67 in the UK, you stop paying NI, and you can start to take your State Pension of £9,300 per year.
With the removal of NI at 67 (but still paying tax at 20% on income over £12,579) and taking the State Pension:
And this will boost your income and, thus, your comfort level.
However, if you retire early, you may not want to wait until you get the pension boost at 67 to start enjoying your retirement. But, what can you do to boost your income?
Well, in the last few newsletters, I have been looking at ways that you could increase your pension. I have been writing about using side-hustles to make some extra cash; see Issue Number: -97 — When is a hobby a side-hustle?. I have also started a series of newsletters on turning your hobby into a side-hustle (with more to come):
But is there another way?
Well, yes, you can dip into your savings to pay yourself a ‘State Pension’ until the State Pension kicks in and then preserve what is left of your savings as a rainy day fund. Or, you can go for a long-term drawdown of your savings and increase your pension income over several years.
But how much will this cost?
That is tough to answer, as the maths requires many assumptions. It depends on whether you are just emulating the State Pension (a sort of Self-funded State Pension) until you receive it or enhance your pension long-term.
Self-funded State Pension
How much money do you need?
You have to cover the State Pension, £9,300 per year, plus the NI payment of 13.25% on any income over £12,500. You also have to factor in inflation, which will impact the State Pension. All a bit tricky, but the amount of money you would need can be calculated using:
S = (A(1 - T) - N(L - P)) / (1 - T - N)
Where:
S = Money needed to mimic the State Pension for a year — what you take from savings
A = State Pension = £9,300
T = Income Tax = 20% (0.2)
N = National Insurance = 13.25% (0.1325)
L = Tax/NI threshold = £12,500
P = Private pension per year
If we put the numbers in, we get:
S = (((9,300 x (1 - 0.2)) - (0.1325 x (12,500 - P))) / (1 - 0.2 - 0.135)
This gives:
S = 7,440 - (1656.25 - (0.1325 x P) / 0.665
S = 7,440 - 1656.25 + (0.1325 x P) / 0.665
S = 5783.75 + (0.1325 x P) / 0.665
(Please check the above maths, and let me know where it is wrong.)
Which gives a good approximation of the amount you need to take from savings. Some worked examples:
A gross private pension of £20,000 per year plus a State Pension would give you a net pension of £25,940 per year. To achieve the same income level without the State Pension would need to take £12,600 from savings per year.
A gross private pension of £25,000 per year plus a State Pension would give you a net pension of £29,940 per year. To achieve the same income level without the State Pension would need £13,600 from savings.
A gross private pension of £30,000 per year plus a State Pension would give you a net pension of £33,940 per year. To achieve the same income level without the State Pension would need £14,600 from savings.
You get the idea.
Long-term drawdown
Another approach is the long-term drawdown from savings to achieve the greatest level of pension possible for as long as possible.
You initially draw down heavily on your savings to achieve the maximum income and then ease back on raiding your savings when your State Pension starts.
The significant risk with this approach is that you might run out of savings before you die, or you might die with a bank account full of money.
The maths here is complicated and requires a spreadsheet to model the numbers. Plus, you need to make numerous assumptions, such as inflation rates and savings growth.
I have constructed such a model, which, I will admit, is very crude, but it gives you an idea of what to expect. In the model, I have assumed an annual rate of interest on my savings of 2% (that seemed reasonable, but the way the stock market is currently behaving and world events, who knows) and inflation at 5% (initially, this seemed high, but with inflation approaching 10% in the UK it now seems low). I came up with the inflation figure of 5% based on a crude 25 year ‘rolling window’ average of inflation in the UK over the last 50 years.
Other assumptions in the model include no changes in tax rates, an increase in the State Pension in line with inflation (unlikely) and an increase in the tax threshold in line with inflation. And I already know one of those is wrong, as the tax threshold will not be increasing in the UK over the next 3–4 years.
Using the model, I can see that if I was 60 this year and retired with a private pension (before tax) of £20,000 per year, and a savings pot of £150,000 (yes, that is a lot), then if I took the pot to zero over the next 25 years, I could take £13,750 from the pot this year and then adjust that by inflation until I am 67. I then reduce the money taken from savings because the State Pension starts, and I stop paying NI.
The image below shows this in operation.
According to the model, I could raise my gross pension from £20,000 per year to £33,750, which is £26,600 net. And that would certainly improve my retirement!
So this shows how I could use my savings (or a pension lump sum) to boost my pension. However, the above is full of assumptions, and one big problem with the approach is if I live beyond 85, I will have no savings.
Please note I am not a financial advisor. I am writing about what I have read over the years about money and preparing to retire. This is not financial advice. I am not advocating the drawdown pension.
Useful links
UK Government Website:
Next week
Next week in issue -87, I will look at getting your affairs in order and why it may not be too early to start.
Thanks
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Until next time,
Nick
PS, If you have something you would like to contribute to the newsletter — a story, advice, anything — please get in touch.
Please note: I am not a financial advisor. When I am writing about money and financial matters, it is based on things I have read about money and about preparing to retire. IT IS NOT FINANCIAL ADVICE.