This is part five of a series on how to maximise your ISAs and SIPPs to achieve financial independence.
Welcome retirement fans! We’re now at the pivotal point on our journey to maximise our ISAs and pensions to achieve financial independence (FI). Together we will walk through the calculations that’ll enable you to create a robust plan to power you towards a happy independence day.
The story so far:
- Part one set out the FI problem of retiring early using UK tax shelters.
- Part two explained why personal pensions beat ISAs later in life.
- Part three revealed the core principles when balancing your ISAs versus your pensions.
- Part four showed how to choose a credible sustainable withdrawal rate (SWR) to fit your situation.
Like an excitable schoolgirl hoisting her hand in class and insisting “pick me, pick me!”, part five has now arrived on the scene to illustrate the sort of FI calculation you’ll need to do, via a simple case study.
We will cover:
How to calculate the amount of capital you’ll need to have in your ISA portfolio to sustain you until minimum pension age.
The monthly investment savings that’ll put you on course to hit your target ISA figure.
The same calculations for your pension so that the total portfolio should last for the rest of your life.1
These calculations will account for your income, spending, the riptides of the UK tax system, the dangers of withdrawing from a retirement portfolio, and maximising your tax shelters. It will incorporate pragmatic expected investment return assumptions.
Let’s first survey the tax battlefield on which this game is played.
Income layer cake
This is the income tax and national insurance situation for an employee living in the UK (except Scotland) and earning up to £100,000 per year.
My apologies to the self-employed, Scottish income taxpayers, anyone earning over £100,000, and all others whose position varies from the above.
It’s important we navigate just a section of the tax maze initially, so we can establish some guiding principles. We can build out case studies from here, or you can customise the calculation to your own circumstances. The Low Incomes Tax Reform Group has produced an excellent summary of the broader UK tax terrain.
The income layer cake is useful for spotting things that are often overlooked, such as basic rate taxpayers pay 32% tax on income when you include National Insurance Contributions (NICs). Higher rate taxpayers pay 42% tax on income.
Basic rate taxpayers have, at most, £25,500 net income available to max out their ISA, without even looking at the demands of living expenses and pensions. I appreciate I’m skipping a boatload of exceptions – trading allowance, property allowance, dividend allowance, marriage allowance, child benefit, personal savings allowance, student loans, Scottish income tax variations… [loses the will and dies].
Okay, I’m not dead but I’ll soon wish I was. Let’s combine the income tax layer cake with a simple case study to illustrate our FI calculation. Enter an aspiring millennial FIRE-ee known as The Agglomerator.
This young upstart wants to hit FIRE as soon as possible without living in a caravan. The Agglomerator boasts these FI vital statistics:
- Annual salary: £60,000
- Other income: £3,000 pension match (Up to 5% of salary)
- Salary sacrifice: Yes, but paid employee NICs only
- Living expenses: £20,000
- FI net income required: £20,000
- Existing assets: £0
- Age: 30
- FI in: 16 years
- ISA bridge to pension: 12 years
- Minimum pension age: 28 years’ time when age 58.
- State Pension age: 38 years’ time when age 68.
Here’s The Agglomerator’s income layer cake showing how much he will contribute to his pension and ISA, after expenses and tax. (Scroll the spreadsheet to the right for the full shebang.)
The full 5% pension match is claimed, of course, but all of The Agglomerator’s higher rate earnings are protected from tax by being herded into the pension.
The Personal Allowance is completely absorbed by living expenses.
There’s £22,287 left per year from Basic rate tax band earnings after pension contributions. More than one-third of that goes on living expenses, and the rest takes cover in the ISA.
Nothing is left for taxable investment accounts (GIAs) or Lifetime ISAs (LISAs).
Tax paid is £10,952 (It’d be £16,666 without any tax relief). The Agglomerator’s average tax rate is 17.38%.2
You can verify your own tax obligations with a friendly tax calculator.
The Agglomerator invests £32,000 annually – split into:
- £14,323 ISA contributions.
- £17,724 pension contributions.
That contribution level will get The Agglomerator to FI in 16 years providing he can stay off the avocado toast
You can’t live on £20,000 a year? What’s wrong with you, you clown car driving, latte sipping snowflake? Want to retire and use central heating do you? Pah! MMM is going to punch your face off!
Excuse me. Wrong audience. Sure, this case study is going to differ from your own situation in a ton of ways, but the basic principles can be bent into your shape.
The ridiculous assumption I’m making is no promotions or side-hustles during the entire 16 year FI run, despite the fact that The Agglomerator is a determined, young go-getter with plenty of skillz. (I believe in that guy!)
Also, this is a meal for one. Two can usually live more efficiently. Although I suppose there’s always the danger that two becomes three then four…
FI calculation here we come
The key variables are:
- How much do you need to live on?
- For how long?
From here, we can play around with our investment contributions, saving period and expected returns to solidify our numbers.
The Agglomerator needs £20,000 to live on.
He guesses that he can build his portfolio to FI critical mass in 16 years. His raw FI numbers look like this:
Withdrawal age: After 16 years The Agglomerator will be 46 and living off his ISAs. He can access his workplace/private pensions from age 58.
Portfolio duration: his ISAs must last a minimum of 12 years from age 46 to 58.
The total portfolio must last until his clogs pop. Life expectancy data suggests that from age 46 The Agglomerator could keep on trucking for over 50 years. If you’re part of a couple, one of you might well last longer. If you don’t kill each other first.
SWR required: This is time dependent, among other things. See our FI SWR table.
- We’re using the pessimistic green numbers on the table for our case studies.
- Any time period over 40 years equals a 3% SWR.
- We also need a separate, time-bound SWR to ensure our ISAs don’t run dry before we make minimum pension age.
The Agglomerator chooses a 6.5% SWR for his ISAs. That figure is a downbeat compromise between the 10-year SWR of 8% and the 15-year SWR of 5%.
Net income required: the amount you want to live on after tax. (The figures used throughout are in today’s money as we assume a real rate of investment return and inflation-adjusted expenses, income and contributions.)
Gross income required: The pre-tax income you need to pay your taxes and your living expenses. That’s not an issue for ISA withdrawals because they’re tax free. Pensions are subject to income tax on withdrawal, and the rate that will apply in the far future is anyone’s guess.
What to do?
We base our gross income calculation on today’s tax regime. Insert your own Tax Rate of the Future, if you prefer. See the Gross income calculation section below for more.
FI capital required:
ISA capital = net income / SWR
For example: £20,000 / 0.065 = £307,692
Total portfolio = gross income / SWR
For example: £20,589 / 0.03 = £686,300
You may well still be drawing some of your income tax-free from your ISAs by the time you hit minimum pension age, but we play it safe and base the total portfolio capital requirement on gross income. This gives us a little wiggle room in case tax-rates worsen or some other factor goes against us.
GIA capital could be determined using your net income, if you’re confident that your account will remain stumpy enough to stay within the bounds of your tax allowances. Gross income is safer but we’ll have to come back to this in the next episode.
Capital required in pensions by the time you FI:
Total portfolio capital minus ISA/GIA capital. For example, £378,608 in the case study.
Monthly investment: The investment contributions wrung out of our income layer cake are poured into an investment target calculator to ensure we can hit our FI capital bullseye in the swiftest possible timeframe.
Investment target calculator
Now let’s turn to the Investment Target Calculator from Candid Money. Other Investment Target calculators are available.
The calculator enables us to dial up the monthly contribution required to hit our FI capital targets. If our various assumptions don’t quite marry up then we can play with the variables a little, especially the saving period and the balance of contributions we make to our ISAs and pensions, as revealed in our layer cake.
The calculator looks like this:
Target amount = ISA capital figure from the previous table.
Existing investments = Zero for The Agglomerator but you may be in better shape.
Saving period = Estimated time to FI. It’s 16 years in this case.
Annual investment return = The expected real return figure of your portfolio.
We’re choosing the rates of return for FCA prescribed projections. Yes we are.
The FCA’s current expected returns are modest in comparison to the historical averages. Their midpoint projection for equity is a 4% annual real return over the next 10 to 15 years. They offer a range of 3% to 5%.
The midpoint for conventional government bonds is a trippy -0.5%, ranging between -1% to 0%. Safe havens don’t come cheap these days.
Why consult some financial Mystic Meg when your actual returns will assuredly be different from the above? Well, the model needs a returns figure as a ranging shot on the future.
If reality proves worse than forecast then you’ll undershoot, or will need to invest more. Ideally things turn out nice again, and you’ll arrive early.
At the planning stage, our job is to use a figure that isn’t too sunny but doesn’t crush our spirit either. Pragmatism rules. Despair can go do one.
Here’s some alternative forecasts if you don’t like the one I’ve used.
The Agglomerator has a high risk tolerance so we’ll go for an expected return of 4% based on a 100% equities accumulation portfolio and a long-ish 16-year time horizon.
An 80:20 equity:bonds portfolio would give us an expected return of 3%.
(4% x 0.8) + (-0.5% x 0.2) = 3.1%
A 60:40 equity:bonds portfolio would give us an expected return of 2%.
(4% x 0.6) + (-0.5% x 0.4) = 2.2%
Income = Investment income; 0% because it’s included in our annual investment return figure, which is a total return incorporating dividends and interest.
Income paid as = ISA setting because we’re contributing to an ISA! Use the same setting for your pension income, which also grows tax-free.
Are you a taxpayer? = Non-Taxpayer as we’re in an ISA. Again, use this setting for your pension as we deal with tax concerns separately.
Annual inflation rate = 0%. Our annual investment return is a real (i.e. after-inflation) return, and we assume that our contributions will be annually up-weighted for inflation.
The result = £1,200 monthly contribution required to hit The Agglomerator’s ISA capital target. Or £14,400 per year.
But you’ll notice he can only squeeze £14,323 out of his layer cake. Can The Agglomerator drum up the extra £7 per month? He mentally resolves to eat a few less pies and then gives the green light to Operation FU.
If the gulf between desire and reality is a little greater, we can adjust.
The main lever to pull is saving for longer. We can reach the same target with a lower contribution level by taking more time.
An 18-year saving period in this case study takes a fair bit of pressure off the ISA bridge. Declaring FI at age 48 means funding a 10-year gap to the minimum pension age. The Agglomerator could then use an 8% SWR for his stash.
£20,000 income / 0.08 SWR = £250,000 ISA capital target
He’d still need £686,300 across the entire portfolio but his pensions would do more of the work in this scenario:
£686,300 – £250,000 = £436,300 pension capital target
The Agglomerator’s pension contributions are far more tax efficient than his ISA contributions, so FI gets easier the more his pensions do the heavy lifting.
You can also calculate your pension contributions in exactly the same way as the ISA example above.
The target amount is your Total Portfolio Capital figure minus your ISA / GIA capital figure.
State Pension and defined benefit reinforcements are covered in the SWR bonus section below.
The maximum contribution you can make into your ISAs is £1666.66 per month or £20,000 per year.
If you need more than that to bridge your gap to minimum pension age then GIAs are the place to turn.
If your ISA bridge is very short then you’d be better off funding it purely with cash rather than a portfolio of volatile assets.3
This is known as liability matching. My cash assumptions lead me to believe that any gap of eight years or less should be dealt with by stockpiling cash. I’ll deal with this in more detail in the next episode but, for now, know that the FCA’s expected real return on cash is -1% per year.
Gross income calculation
Most FIRE-ees will pay income tax on their pension income when it tops £16,666 a year. (More on where I conjured that figure from below.) Our capital target figure therefore needs to take into account the taxman’s slice.
To calculate the gross income required to do this, we’ll use the very nice pension tax calculator devised by Which?.
Here’s the gross income calculation for The Agglomerator, who needs £20,000 in net income per year:
Amount you’re withdrawing = Gross income. You won’t know this figure until you’ve played around a little. I just typed my net income into this field and kept upping it until the calculator flashed up the net income result I wanted (in the Total lump sum after tax field).
Lump sum from an income drawdown plan = No. This makes the calculator show the result in the most convenient format for planning purposes. I’ll explain my rationale on this in a sec.
Do you live in Scotland? Well, do you punk? You’ll get results tailored for Scottish income taxpayers if you tick this box.
Total tax you will pay = Amount you chip in for schools, hospitals, roads, police, social security, the military, and so on (seems like quite a good deal).
Total lump sum after tax = The net income you can expect to get, using today’s tax regime, accounting for your Personal Allowance and 25% tax-free cash.
I’ve set the calculator so it shows your tax position if 25% of your income comes from your pension’s tax-free lump sum. That means I’ve set the calc to Uncrystallised Funds Pension Lump Sum (UFPLS) mode.
That’s a mouthful in anyone’s book but the assumption doesn’t mean you have to use UFPLS in retirement – drawing 25% of your income tax-free and 75% taxed, every time you dip into your pot.
Depending on how you use your pension, you could take your 25% tax-free lump sum entirely upfront and invest it all in ISAs and GIAs. If you can tax-shelter that amount quickly enough, and draw 25% of your income from it per year, then the result is the same as UFPLS.
I’m ignoring the present day option to continue to contribute your full annual allowance into your pension, if you choose to take your 25% tax free lump sum only. I’m also discounting the fact that some could probably live tax-free for several years on their lump sum. There are many roads to Rome.
Some commentators will also warn that the 25% tax-free cash could be scrapped by a future government sniffing out bigger tax revenues. Yes, anything’s possible. Please adjust your personal calculation as you like.
My simplifying assumptions give us a rule-of-thumb for how much each person can live on tax-free using pensions:
£1 / 0.75 = £1.333 (how much each £1 of net income is worth after 25% tax relief).
£12,500 x 1.333 = £16,666 (total amount of tax-free income you can draw from your pension including the 25% tax-free amount).
Remember the State Pension is taxed as normal and for the sake of sanity I have to leave lifetime allowance calculations on the sideline for now.
Investment fees and the State Pension SWR bonus
We’re so nearly there. The other big factors are the SWR drag of investment fees once you’re a deaccumulator and the SWR spike you get from the State Pension and any defined benefit pensions that may turn up at various milestones on your FI journey.
The SWR drag of investment fees is succinctly explained here.
Thankfully you only need to subtract 50% of your investment fees from your SWR. This is for arcane reasons best explained via the link above.
That 0.25% deduction would reduce The Agglomerator’s Total Portfolio SWR to 2.75% for a retirement over 40 years. (The deduction also applies to the ISA SWR.)
£20,589 / 0.0275 = £748,690 capital required, instead of £686,300, for a 3% SWR.
Happily we can neutralise this blow with the State Pension SWR bonus.
If you expect your State Pension, or defined benefit (DB) pension, to charge over the hill on the day you declare FI, then just deduct those cashflows from your gross income requirement, and calculate your reduced FI capital based only on the income you need to sustain from your portfolio.
Most of us are not so lucky, except that we have the amazing Big ERN from Early Retirement Now on our side. He’s calculated how much of a bump your SWR gets from an income stream that won’t arrive for many years down the line, like the State Pension.
Read ERN’s piece on Social Security and Pensions for the full lowdown.
Pay careful attention to the part from Introducing: Big ERN’s cashflow translation tool up to What if benefits are not adjusted for inflation?
ERN’s formula also works if you have a defined benefit pension on the way.
I’ve applied ERN’s formula and the first table in his post (Impact of cashflows with Cost of living Adjustments) to The Agglomerator’s case study to simulate the impact of his State Pension:
ERN’s formula requires you to estimate the percentage value of your supplementary cashflows versus your FI portfolio.
The full new State Pension provides an annual income of £8,767. You qualify for the full whack by contributing 35 years of NICs.
8767 / 35 = £250.49 (the State Pension income you earn for each qualifying year).
The Agglomerator is due a State Pension worth £6,262 per year if he stops making NICs after 25 years of his working life. Or he could make voluntary NICs in retirement to ensure he brings home the full State Pension from age 68.
His reduced State Pension is worth 0.91% of his Total Portfolio FI capital of £686,300. His full State Pension would be worth 1.28%.
ERN’s table enables you to modify your SWR bonus depending on:
- Asset allocation in retirement – I’ve chosen 60:40 equity:bonds.
- Retirement length – I’ve chosen 50 years.
- Benefit start date – I’ve chosen 22 years after FI because The Agglomerator retires at 46 but his State Pension kicks in at age 68.
- Minimum, Median, or Maximum Value scenarios based on portfolio performance (I’ve chosen the minimum (i.e. the worst scenario) because ERN uses historic US investment returns, which may not be so bright in our future.)
Multiply ERN’s modifiers by the percentage worth of your State Pension and you have your SWR bonus. I’ve marked The Agglomerator’s bonus options in green on the table above: +0.26% SWR for his rump State Pension and +0.36% for his full one.
Either way that’s just enough to cancel the SWR drag of our investment fees. We’ll round down the rest and maybe enjoy a bit more wiggle room in the future.
If your affairs are complicated or you love modelling the detail then check out ERN’s DIY Withdrawal Rate Toolbox – a magnificent and many-headed beast of a spreadsheet. Beware those US investment returns, though.
All together now
There you have it. That’s the full, vanilla calculation, ready to be customised to fit your personal circumstances.
Naturally, projecting 50 or 60 years ahead involves a ludicrous number of assumptions. No plan survives contact with reality, but my aim here is to at least provide a rational platform from which you can launch yourself into the future.
I can understand the reasoning of anyone who wants to drop their SWRs by another 0.25% or 0.5%. The lower you go, the safer you may be, the longer FI will take, the more likely you are to die with pots of cash in the bank. That’s the trade-off.
Raise your SWR if you’re prepared to leave more to chance, or to work part-time, learn some SWR kung-fu, or can fall back on a few Plan Bs – equity release, offset mortgage, downsize, rental properties, annuities, emergency fund, inheritance, a raft of defined benefit pensions, dying young
The baseline SWR is most likely to be needed when market valuations are high. Now is such a time.
Next episode: I’d like to cover liability matching, more on asset allocation, GIAs and a few more case studies dealing with different circumstances.
Take it steady,
- Disasters of unprecedented proportions notwithstanding.
- The 2% employee NICs don’t quite line up with the higher rate tax band, so the spreadsheet departs from reality to the tune of about £2 in NIC payments per year.
- Theoretically a ladder of inflation-linked UK government bonds would be ideal, but that’s expensive today and also technically difficult.