Q&A: What am I saving for? When can I spend my retirement savings?

10/1/2020

What's the point of saving?

Hi Heather,

Based on the things you told us about investing, my husband and I started putting £125 per month each into our SIPP pension. I hope this isn’t a silly question but what are these savings for? When can we expect to start spending that money and should we try to spend it in specific ways or on specific things? Both my husband and I are 30, we don’t plan on having children and our jobs have fixed pension benefits.

Thanks
Flora

Dear Flora,

That’s a great question. While everyone has a different value system, there are two main reasons that I strongly recommend that people put money into a self-invested pension plan or SIPP a) flexibility and b) security including funds to help pay a mortgage off early.

A SIPP can be better than a stocks and shares ISA, in some cases, because you effectively pay less tax and because you can’t use the money until you are about 58 so it forces you to save.

Let’s talk about each reason in turn:

The first reason: is flexibility over when to retire

In the past, a lot of work-based pensions (aka defined benefit pension plans) used to allow early retirement from between the ages of 55 and 60, most of these type of scheme are being completely phased out and are instead being linked to the state retirement age which for you is currently expected to be 68. There is talk of moving this to age 70, so this is a future possibility.

Whatever happens, the funds that you build up in your SIPP can be taken from 10 years before the state retirement age. This means if the state retirement age moves to 70 you will still be able to use money that’s sitting in your SIPP from the age of 60.

If you and your husband are putting £125 each into a SIPP then when you are 55 years old, you and your husband’s combined pot of savings would be worth £135,000 if the pot of money only grows fast enough to keep up with inflation of about 3%; if you get growth equivalent to the average stock market return of 7% then you would have £250,000 at the age of 55 and if you get an average stock market return of 10% you would have £410,000 saved up.

At age 60 the figures would be £180,000 @ 3%, £375,000 @ 7% and £700,000 @ 10%.

These sort of returns aren’t cuckoo. According thebalance.com, “the S&P 500 Index, delivered its worst twenty-year return of 6.4% a year over the twenty years ending in May 1979. The best twenty-year return of 18% a year occurred over the twenty years ending in March 2000.”

Various sources suggest the S&P 500 has returned 10% before inflation if you buy and hold the money you invest into it. But of course, it’s useful to remember that this past success doesn’t guarantee that future returns will be as good.

Right now you would struggle to find a bank account that gives you an interest rate of 1.5%.

Back to flexibility on when you retire, however, unless you believe the US has no room for growth, then this total of £250/month you are saving could amount to a lot of money over a 25 to 30 year period and this would allow you to retire with a decent income well before the state retirement age.

If your mortgage is fully paid off by the time you retire then your cost of living could be low enough that even a modest growth in the SIPP would provide a comfortable income before your state pensions and work-place pensions kick in.

The second reason: to save the money is the added security from having extra retirement income

Having money in a SIPP means you can top up your retirement income.

Having the SIPP would mean you have 5 sources of income:

two state pensions – yours and your husand’s – (keep in mind that we have no idea how the level of state pensions could change over time);
your workplace pension;
your husband’s workplace pension; AND
the SIPP.

If the pension income from your jobs is lower than your final salary having access to extra funds will mean you can more or less maintain your lifestyle. This will be especially important if one person lives a lot longer than the other.

There is one special feature that the SIPP has but all the other 4 pensions do not: and that’s the fact that if you or your husband dies the state pension stops coming through and the work-place pension either stops completely or is massively reduced. However, whatever money is outstanding in the SIPP would fully transfer to the spouse without penalty.

Just to be clear, I will make that point twice: a work-place pension either dies with the person and at that point the spouse receives nothing or, from that point, the spouse gets a heavily reduced benefit – usually 50% of one-third of the amount that was being received before their spouse died.

A LOT OF PEOPLE forget this about SIPPs and other defined contribution pensions. I won’t go into the differences between defined benefit and defined contribution pension plans here but if someone is interested go to themoneyspot.co.uk and leave me a voicemail with your request.

Finally, when can you expect to start spending that money and should you try to spend it in specific ways or on specific things?

Technically, the plan is that you will never have to spend the capital but can just spend the growth.

If the fund is worth £250,000 when you start drawing from it and you are earning a 10% return per year at that point, then you could just withdraw the 10% (i.e. £25,000) or less and spend that.

If your withdrawal rate is lower than the growth rate of the fund then your retirement would continue to grow even as you take money out.

Note that some research suggests that the ideal withdrawal rate to maximise the likelihood that the money will never run out is 4%. But given you have pension income from your jobs in addition to the state retirement and you’re not worried about passing wealth on to children you could be more aggressive than this.

As for how you spend that money, well that is up to you and is a great problem to have. Having more money doesn’t only mean more holidays, it also means you can buy private health insurance which might be a necessity to avoid NHS waiting lists at a time when health problems are more likely. This would give you a lot of peace of mind.

Ability to pay mortgage off early

One thing worth adding, is a note that once you can withdraw money from your SIPP you are allowed to take 25% out as a tax-free lump sum. If your household had £250,000 saved up, you could take £62,500 out in one go which could be used to clear all or most of your mortgage.

You would then be allowed to take the rest out as an income or you could buy an annuity – with an annuity you essentially buy a fixed income which keeps being paid to you for the rest of your life.

I wouldn’t recommend an annuity for you given you have two fixed pensions coming in already, you don’t need the extra security and annuities don’t tend to be worth the money now that interest rates are so low. What you could do instead of buying an annuity is withdraw what you need from the SIPP every year. You would pay taxes based only on what you take out and could manage the withdrawals to minimise the tax bill.

I hope this helps.

Heather