Tuesday, 16 April 2013 12:44
Real life case study: Ian Brookes of Critchleys Financial Planning
Ian Brookes CFPCM of Critchleys Financial Planning discusses a challenging and complex retirement planning case where patience and cashflow planning paid off and saved the client considerable amounts of tax.
I originally met with Mr Miles five years before our second meeting in the autumn of 2012.
At our first meeting, I had proposed he undertake a full Financial Planning review in preparation for his retirement, which at that time would be at some point in the next five years, however he declined at the time.
Mr Miles is now 68 and contacted me again last autumn to request that we again discuss his impending retirement having remembered our original conversation regarding retirement income and expenditure analysis, together with lifetime cashflow forecasting, in order to create a structured retirement plan.
Mr Miles is a senior employee in the City, working five days a week and earning around £93,000 per year gross. He wished to retire in 6 - 12 months time. The daily commute and pressure from his family to 'slow down' was at the heart of this decision.
This is a real-life case study, names and some other details have been changed to protect confidentiality.
At the next meeting, he confirmed that he is already in receipt of a final salary pension amounting to £35,000 per annum in addition to his salary. He is also contributing to his employer's group personal pension plan (GPP) which was valued at £250,000. He was also making personal contributions of £10,000 pa gross, alongside a further £10,000 pa gross being paid by his employer.
Between Mr Miles and his wife, they also held £70,000 in stocks and shares Isas, a further £100,000 held in collective investment funds, out of which capital was being moved periodically into their Isas, in order to maximise their annual Isa allowances. They also held £100,000 in cash on deposit, from a recent inheritance.
They own their main residence of £900,000 and a rental property worth £150,000 that had a £50,000 interest-only mortgage against it. Total net worth is therefore in the region of £1.52m, after the mortgage debt.
He was also deferring the drawing of his state pension from age 65. Mrs Miles had already retired and is in receipt of her state pension of £4,000 pa, her only source of retirement income.
Mr Miles was initially concerned with the possible effect on the potential reduction of Male Annuity rates prior to the introduction of the EU Gender Pricing Directive last December. He was also mindful of the fact that he needed to ensure that his wife would be financially secure should he pre-decease his wife. However, they both had concerns regarding the effect of inflation reducing the spending power of the retirement income, also how best to structure their retirement planning so that they both had maximum flexibility over the death benefits. They both had views on how long they might live based on mixed family history of longevity, which added further uncertainty in their minds as to how best to maximise the value of the pension over the longer term.
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The next step in the planning process was to ask them to complete an expenditure analysis questionnaire to help determine their expected annual expenditure in retirement, together with any short term one off expenditure requirements. This revealed the fact that they wanted to spend £40,000 pa net of tax (inclusive of holidays of £5,000 pa for the next 10 years) - £3,333 pm. As well as spending approximately £10,000 on repairs to their house in the next 12 months.
I then asked Mr Miles to provide details of his current state pension income entitlement, in order to determine its current value should he start drawing it in the near future. He came back to me with a figure of £10,000 pa. We decided that he would continue to defer the state pension until fully retired.
I then calculated his total secure pension income (should he decide to stop working immediately) to be £45,000 pa gross - £37,116 pa net (state and final salary scheme). Bearing in mind Mrs Miles's state pension income of £4,000 pa gross as a non-tax payer, their total net income would be £41,116 pa, thus exceeding their £40,000 pa net target expenditure. Clearly their state pensions and his final salary pension would have some degree of index-linking which would help keep pace with increases to the cost of living.
As with all clients undertaking a financial plan, it is important that my clients choose their own assumptions, such as setting the rate at which income and expenditure should increase annually - to then be kept under review at future planning meetings.
After some thought and discussion they chose 2.5 per cent pa for annual increases to the final salary and state pension income. Annual cost of living increases were set at four per cent pa to err on the side of caution. This meant that expenditure would out pace their income over the coming years by 1.5 per cent pa. As they were concerned by the potential effects of long term high inflation, they realised that their accumulated investments and any future investment would need to be managed appropriately to help bridge the potential decline in spending power of their income and to try and maintain the underlying capital value in real terms, should it be required in the future to potentially meet long term care costs, or pass on wealth to their two children.
Investment risk profiling
The next step was to undertake a risk profiling exercise with them. We completed a separate risk profile questionnaire for generating retirement income from the pension. It was clear from our conversations that they would be prepared to take some risk when drawing pension income, in light of their incomes from the final salary scheme and state pensions. The main focus was still however on maintaining flexibility over the death benefits.
The second risk profile questionnaire was used to determine what risks they would be prepared to take with their remaining investments when generating income and capital growth. This showed that again they would be prepared to accept some risk to capital in pursuit of growth to help generate income and keep pace with inflation. We used a target rate of return of inflation plus 0.5 per cent pa - so 4.5 per cent pa net of fees based on our initial inflation assumption – to be measured over a five year rolling period. We also used their risk profile to assess the suitability of the current investment strategy of their existing investment portfolio which had been built up on an ad-hoc basis with the bank. This demonstrated that their current portfolio was too heavily weighted towards equities and that they could afford to de-risk a little while still maintaining an asset allocation model that would have the potential growth prospects to meet their target rate of return.
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Strategy and cashflow forecasting
It was at this point that I introduced their cashflow forecast to show the potential 'What if' scenarios of drawing the pension in various different styles, such as level annuity, escalating annuity, investment linked annuity, and income drawdown. This is where using Truth software comes into its own, it can very easily create the 'what if' scenarios and help paint a picture of the future, which in turn can help clients make more informed retirement decisions.
The option they most favoured was flexible income drawdown, due to his secure income from the final salary scheme and state pension exceeding the £20,000 pa minimum. They were attracted to the ability to gain control over the capital in the pension fund over a relatively short period of time, 4-5 years, and not have to worry about securing death benefits. Once Mr Miles reached full retirement, they then wished to reinvest the flexible income drawdown income withdrawals in-line with their inflation-linked target investment return.
Assuming current income tax rates continue, Mr Miles is likely to remain a higher rate income tax payer in retirement based on the total gross income from the final salary and state pensions. The risks however of tax rates becoming more generous in the future were pointed out. However, the ability to have complete control over the pension capital for the future was most important to them.
Recommendations
As an immediate income tax planning measure, he made a lump sum contribution of £19,000 gross out of surplus capital which would bring total taxable income to below £100,000 thereby regaining Mr Miles' personal allowance of £8,105 for this tax year, the equivalent of 60 per cent tax relief across this band of earnings. This is something that Mr Miles was not aware of and wished he had known about before now.
Once fully retired, we decided that he would adopt a strategy of transferring the GPP to a Sipp that would allow flexible income drawdown, while keeping total taxable income (including flexible income withdrawals from the Sipp) below £100,000 gross pa in order to retain his income tax personal allowance. Having checked the additional contribution of £19,000 gross would not fall foul of the tax-free lump sum recycling rules, once the maximum tax free cash is drawn at retirement the tax-free lump sum would then be used to repay the interest only mortgage of £50,000 as they wished to clear it in early retirement.
With their remainder spare cash of £74,800 (after the pension contribution and cash being set aside for the repairs to the house) we created an emergency fund that they felt comfortable with of £40,000 - broadly equal to about one years' expenditure.
With the remaining surplus cash they decided to invest this alongside their existing investment portfolio to meet the target rate of return. The portfolio would also be added to with any surplus tax-free cash at retirement and each time Mr Miles took a further income withdrawal from his Sipp.
The couple's existing investment portfolio was then moved into our investment service, as we can provide professional investment management and ongoing Financial Planning review meetings for broadly the same cost as the existing portfolio's total expense ratio. Currently they are only receiving impersonal retail fund management guidance for this cost.
Inheritance tax planning was of lesser importance at this stage while Mr Miles settled into his retirement. They suggested that they may not be able to manage their £900,000 house in the future and may need or wish to downsize, thus providing further scope for this planning service in the future.
What happened next
They are now both happy with the retirement planning advice and can see the value of professional Financial Planning to help provide a coherent strategy. This has given them peace of mind that once Mr Miles has fully retired, they will be able to immediately concentrate on enjoying retirement rather than reacting to the changes after it happens.
A six-monthly review will be conducted after the initial Financial Planning has taken place, as I find this helps clients take stock of the changes once the dust has settled. Cashflow forecasting and investment review meetings will then revert to 12 monthly thereafter, with periodic contact in between as required.
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I originally met with Mr Miles five years before our second meeting in the autumn of 2012.
At our first meeting, I had proposed he undertake a full Financial Planning review in preparation for his retirement, which at that time would be at some point in the next five years, however he declined at the time.
Mr Miles is now 68 and contacted me again last autumn to request that we again discuss his impending retirement having remembered our original conversation regarding retirement income and expenditure analysis, together with lifetime cashflow forecasting, in order to create a structured retirement plan.
Mr Miles is a senior employee in the City, working five days a week and earning around £93,000 per year gross. He wished to retire in 6 - 12 months time. The daily commute and pressure from his family to 'slow down' was at the heart of this decision.
This is a real-life case study, names and some other details have been changed to protect confidentiality.
At the next meeting, he confirmed that he is already in receipt of a final salary pension amounting to £35,000 per annum in addition to his salary. He is also contributing to his employer's group personal pension plan (GPP) which was valued at £250,000. He was also making personal contributions of £10,000 pa gross, alongside a further £10,000 pa gross being paid by his employer.
Between Mr Miles and his wife, they also held £70,000 in stocks and shares Isas, a further £100,000 held in collective investment funds, out of which capital was being moved periodically into their Isas, in order to maximise their annual Isa allowances. They also held £100,000 in cash on deposit, from a recent inheritance.
They own their main residence of £900,000 and a rental property worth £150,000 that had a £50,000 interest-only mortgage against it. Total net worth is therefore in the region of £1.52m, after the mortgage debt.
He was also deferring the drawing of his state pension from age 65. Mrs Miles had already retired and is in receipt of her state pension of £4,000 pa, her only source of retirement income.
Mr Miles was initially concerned with the possible effect on the potential reduction of Male Annuity rates prior to the introduction of the EU Gender Pricing Directive last December. He was also mindful of the fact that he needed to ensure that his wife would be financially secure should he pre-decease his wife. However, they both had concerns regarding the effect of inflation reducing the spending power of the retirement income, also how best to structure their retirement planning so that they both had maximum flexibility over the death benefits. They both had views on how long they might live based on mixed family history of longevity, which added further uncertainty in their minds as to how best to maximise the value of the pension over the longer term.
{desktop}{/desktop}{mobile}{/mobile}
The next step in the planning process was to ask them to complete an expenditure analysis questionnaire to help determine their expected annual expenditure in retirement, together with any short term one off expenditure requirements. This revealed the fact that they wanted to spend £40,000 pa net of tax (inclusive of holidays of £5,000 pa for the next 10 years) - £3,333 pm. As well as spending approximately £10,000 on repairs to their house in the next 12 months.
I then asked Mr Miles to provide details of his current state pension income entitlement, in order to determine its current value should he start drawing it in the near future. He came back to me with a figure of £10,000 pa. We decided that he would continue to defer the state pension until fully retired.
I then calculated his total secure pension income (should he decide to stop working immediately) to be £45,000 pa gross - £37,116 pa net (state and final salary scheme). Bearing in mind Mrs Miles's state pension income of £4,000 pa gross as a non-tax payer, their total net income would be £41,116 pa, thus exceeding their £40,000 pa net target expenditure. Clearly their state pensions and his final salary pension would have some degree of index-linking which would help keep pace with increases to the cost of living.
As with all clients undertaking a financial plan, it is important that my clients choose their own assumptions, such as setting the rate at which income and expenditure should increase annually - to then be kept under review at future planning meetings.
After some thought and discussion they chose 2.5 per cent pa for annual increases to the final salary and state pension income. Annual cost of living increases were set at four per cent pa to err on the side of caution. This meant that expenditure would out pace their income over the coming years by 1.5 per cent pa. As they were concerned by the potential effects of long term high inflation, they realised that their accumulated investments and any future investment would need to be managed appropriately to help bridge the potential decline in spending power of their income and to try and maintain the underlying capital value in real terms, should it be required in the future to potentially meet long term care costs, or pass on wealth to their two children.
Investment risk profiling
The next step was to undertake a risk profiling exercise with them. We completed a separate risk profile questionnaire for generating retirement income from the pension. It was clear from our conversations that they would be prepared to take some risk when drawing pension income, in light of their incomes from the final salary scheme and state pensions. The main focus was still however on maintaining flexibility over the death benefits.
The second risk profile questionnaire was used to determine what risks they would be prepared to take with their remaining investments when generating income and capital growth. This showed that again they would be prepared to accept some risk to capital in pursuit of growth to help generate income and keep pace with inflation. We used a target rate of return of inflation plus 0.5 per cent pa - so 4.5 per cent pa net of fees based on our initial inflation assumption – to be measured over a five year rolling period. We also used their risk profile to assess the suitability of the current investment strategy of their existing investment portfolio which had been built up on an ad-hoc basis with the bank. This demonstrated that their current portfolio was too heavily weighted towards equities and that they could afford to de-risk a little while still maintaining an asset allocation model that would have the potential growth prospects to meet their target rate of return.
{desktop}{/desktop}{mobile}{/mobile}
Strategy and cashflow forecasting
It was at this point that I introduced their cashflow forecast to show the potential 'What if' scenarios of drawing the pension in various different styles, such as level annuity, escalating annuity, investment linked annuity, and income drawdown. This is where using Truth software comes into its own, it can very easily create the 'what if' scenarios and help paint a picture of the future, which in turn can help clients make more informed retirement decisions.
The option they most favoured was flexible income drawdown, due to his secure income from the final salary scheme and state pension exceeding the £20,000 pa minimum. They were attracted to the ability to gain control over the capital in the pension fund over a relatively short period of time, 4-5 years, and not have to worry about securing death benefits. Once Mr Miles reached full retirement, they then wished to reinvest the flexible income drawdown income withdrawals in-line with their inflation-linked target investment return.
Assuming current income tax rates continue, Mr Miles is likely to remain a higher rate income tax payer in retirement based on the total gross income from the final salary and state pensions. The risks however of tax rates becoming more generous in the future were pointed out. However, the ability to have complete control over the pension capital for the future was most important to them.
Recommendations
As an immediate income tax planning measure, he made a lump sum contribution of £19,000 gross out of surplus capital which would bring total taxable income to below £100,000 thereby regaining Mr Miles' personal allowance of £8,105 for this tax year, the equivalent of 60 per cent tax relief across this band of earnings. This is something that Mr Miles was not aware of and wished he had known about before now.
Once fully retired, we decided that he would adopt a strategy of transferring the GPP to a Sipp that would allow flexible income drawdown, while keeping total taxable income (including flexible income withdrawals from the Sipp) below £100,000 gross pa in order to retain his income tax personal allowance. Having checked the additional contribution of £19,000 gross would not fall foul of the tax-free lump sum recycling rules, once the maximum tax free cash is drawn at retirement the tax-free lump sum would then be used to repay the interest only mortgage of £50,000 as they wished to clear it in early retirement.
With their remainder spare cash of £74,800 (after the pension contribution and cash being set aside for the repairs to the house) we created an emergency fund that they felt comfortable with of £40,000 - broadly equal to about one years' expenditure.
With the remaining surplus cash they decided to invest this alongside their existing investment portfolio to meet the target rate of return. The portfolio would also be added to with any surplus tax-free cash at retirement and each time Mr Miles took a further income withdrawal from his Sipp.
The couple's existing investment portfolio was then moved into our investment service, as we can provide professional investment management and ongoing Financial Planning review meetings for broadly the same cost as the existing portfolio's total expense ratio. Currently they are only receiving impersonal retail fund management guidance for this cost.
Inheritance tax planning was of lesser importance at this stage while Mr Miles settled into his retirement. They suggested that they may not be able to manage their £900,000 house in the future and may need or wish to downsize, thus providing further scope for this planning service in the future.
What happened next
They are now both happy with the retirement planning advice and can see the value of professional Financial Planning to help provide a coherent strategy. This has given them peace of mind that once Mr Miles has fully retired, they will be able to immediately concentrate on enjoying retirement rather than reacting to the changes after it happens.
A six-monthly review will be conducted after the initial Financial Planning has taken place, as I find this helps clients take stock of the changes once the dust has settled. Cashflow forecasting and investment review meetings will then revert to 12 monthly thereafter, with periodic contact in between as required.
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