Garrett Harbron: Advice on getting retirement spending in (the right) order

Retiring clients should be made aware that spending savings in the right order can make a huge difference to their finances, writes Garrett Harbon

As more and more people retire with defined contribution (DC) pensions, it is increasingly important that they get good advice on the most tax-efficient way to draw down their various retirement “pots”. These pots are likely to include not just pensions, but ISAs (individual savings accounts) and taxable savings accounts or investment portfolios.

Our research suggests that choosing the most tax-efficient way to spend these accounts can add years and/or tens of thousands of pounds to a retirement income.

The first question a retiree should settle is how to spend their DC pension. We tested three typical DC drawdown methods:

  • Crystallise and withdraw the whole pension, with 25% tax-free and the rest subject to the person’s highest rate of income tax.
  • Crystallise but just take out the 25% tax-free lump sum, leaving the rest to continue building tax-free, but subject to the person’s highest tax rate on withdrawal.
  • Crystallise and withdraw only what is necessary for regular income needs, with 25% of the drawn-down sum tax-free and the rest subject to income tax.

We looked at the chance the pension would still be paying an income after 30 years in a number of different circumstances.

Consistently the least likely to succeed was crystallising a lump sum. The probability of success ranged from 10% to 60%, depending on whether a relatively high or relatively low income was being sought. By contrast, the most consistently certain to succeed was crystallising only what was necessary to provide regular payments. Here the likelihood of success ranged from about 60% for higher incomes to as much as 90% or so for lower ones. Indeed, this proved the best approach irrespective of tax bracket and whether a pension, ISA or general investment account (GIA) was drawn down first.

Having established the optimum DC drawdown method, we then tested different orders of withdrawal amongst GIAs, ISAs and pensions.

To model the performance of the portfolio over 30 years, we used the Vanguard Capital Markets Model, a proprietary forecasting tool that provides investors with a range of possible future expected returns for a wide range of asset classes.

For our analysis, we assumed the modelled portfolios held a 50/50 stock/bond allocation in each of the tax wrappers, rebalanced annually. All tax rates, thresholds and allowances are based on 2019/20 UK tax legislation. For more details of the assumptions, see Withdrawal order: making the most of retirement assets, Vanguard Research, November 2019.

We looked at which were best able to last the course and which gave the best returns. In all cases across our three chosen tax bands, we found that drawing from the GIA first gave the best results. Whether an ISA or a pension was chosen next did not make much difference (assuming regular crystallisation for the pension).

Show your workings

We can illustrate our findings with two 65-year-old investors, one with £100,000 in each of a GIA, ISA and DC pension, and the other with £1m in each. We looked at how long the first could expect to receive an annual after-tax income of £20,000, including state pension, and the second £123,000 on the same basis. Our model suggested the lower-income retiree could expect well over 10 more years of income if they spent the GIA first, with a median life for their portfolio approaching 45 years. For the higher-income seeker, the extension was around nine years, with a median life of approaching 40 years.

Looked at another way, both retirees could meet their income needs over 30 years with an 85% chance of success if they spent the GIA first. By contrast, each would have to accept a substantial annual shortfall in income – at least £1,500 for the first and about £20,000 for the second – if they wanted to have the same chance with the GIA last (see chart to the left

Our research also showed that spending from the GIA first significantly increases the chances of being able to leave a bequest. We modelled a 65-year-old with three accounts of £400,000. After 30 years, there was a 50:50 chance they would still have at least £60,000 left, having spent £58,000 a year in the sequence GIA, ISA and DC pension. That’s around £50,000 more than if they had spent the pension before the ISA and the GIA (see chart to the left).

These results are perhaps not surprising, given the broad principle that it is better to spend money subject to higher taxes first. But while this is generally true, applying it to an individual will depend on their personal circumstances. For instance, spending a DC pension first may be the most effective way to use a tax-free personal allowance (£12,500 in the 2020-21 tax year). On the other hand, any gains in a GIA should be realised to take advantage of the annual exempt amount for capital gains tax (£12,300 in the 2020-21 tax year).

And for clients with very large assets, pensions can represent a very tax-efficient way to pass on estates to the next generation. For those who want to take advantage of such opportunities, spending their pension first might not make sense.

As with all financial advice, forewarned is forearmed. Retiring clients should be made aware that spending savings in the right order can make a huge difference to their finances. Individual needs and desires may require some compromise, but that should not stop them planning early and planning effectively.

Garrett Harbron is head of UK wealth planning research at Vanguard