Income generating options for you in retirement, Mr Client
19 November 2018
Martin Jarvis, associate consultant, Mattioli Woods looks at how the various options to create retirement income could be explained to clients
Generating a positive income stream can be a complex business. Throughout an individual’s working life, the process seems straightforward. Work, get paid, work get paid, work, get paid and so on. However, what happens at retirement?
From worrying about the nuances of work to the nuances of finances and how to generate an income from savings can be a real problem for clients. Hopefully by the time an individual reaches retirement there will be a nest egg stashed away that can be used to replace this lost income from working. But is there one easy-to-find solution?
Cash is King
Let’s start simple. What about a bank account and simply draw off the savings? While this is fine, there needs a substantial amount to cover an individual for a number of years. For instance, with no investment return, an individual could replace a £20,000 income stream on a sum of £300,000 for 15 years. With a 5% investment growth each year, the longevity jumps to 25 years. Now, there are many different factors to consider when investing, as we know – risk tolerance, time frame and tax to name a few. However, if used correctly, investments can provide a potential longevity boost.
So, if we are looking at investments, what types could be used to provide an income stream?
Safe as houses
A popular method for retirement is a buy-to-let house purchase, with the rent providing the income stream. With what seems like metronomic capital rises also, a buy-to-let can seem like a win-win. Further, with average rental yields at 5%, a relatively stable return is generated.
However, recent changes to the rules around buy-to-lets – including offsetting mortgage costs and stamp duty hikes – has reduced the attractiveness of such investments. When added to a relatively high administration burden of managing the property, income tax on rental receipts, capital gains on sales, as well as potential tenant problems or void periods, maybe buy-to-let properties are not the silver bullet people thought they were.
Even if an investor can stomach the additional cost, there is the lack of liquidity to consider.
So, if liquidity is a problem what about more standard investments:
When best to invest?
If investments are the answer, then let’s throw the hard-earned lump sum at a fund manager and leave them to it. We will even get them to diversify between equities, bond and fixed interest. This way we will have no trouble meeting our income target.
Well, it’s not quite so simple, indeed investments can often appear confusing and abstract relative to the tangible nature of a house purchase, for instance. As with rental receipts there are taxation considerations to be wary off. Although every individual receives a capital gains tax allowance (currently £11,700), if all of the above £20,000 is gain, it’s clear there will be some tax to pay.
So, if tax is the problem;
It’s a nISA time for an ISA
Certainly, ISAs are extremely tax efficient and- given the right structure – can be very liquid and most individuals know the main advantages. Tax-free investment, tax-free growth and tax-free withdrawals. The holy trinity. This strategy can work exceptionally when used for income. In addition, a wide array of investments can be used, including equities, bonds, and fixed interest – therefore ISAs have the ability to cater for the majority of risk tolerances and needs.
However, the annual investment amount, although conducive for regular investment, does not suit a one-off large lump sum.
Again, although ISAs have their advantages, there are issues which may reduce their appeal.
Is there another type of structure that could be used?
Pensions flex their muscles
Your head would need to have been firmly buried in the sand over the last few years not to have heard about the pension revolution. Often seen as complex, archaic and boring structures, the introduction of relaxed income rules have thrust them into the spotlight once more. And being able to take as much income as needed at whatever point is certainly attractive. Add to this very favourable tax treatment within the fund and on death, maybe pensions are the answer.
With contribution allowances falling through the floor over the last few years – plus withdrawals aside from the 25% tax free lump sum being taxed at an individual’s marginal rate – there are again issues with what seems to be the perfect structure.
It’s time for an adVenture
What about more niche investments than the perceived standard assets? Venture Capital Trusts (VCT) offer a tax-free dividend, with no capital gains tax on subsequent sale. They even offer 30% income tax relief on investments up to £200,000 in any one tax year. Similar structures include Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS), which can offer even more advantageous tax treatment
However, it is key to understand these investments are relatively higher risk than the aforementioned. Therefore, investing all of an individual’s savings into one is arguably not the most suitable advice.
The name’s Bond…
With a large lump sum, single premium bonds can provide for a very tax efficient method of investment.
Further, there are advantageous tax treatments to consider. For onshore contracts the insurance company will suffer 20% tax on investment income and realised gains. For offshore contracts there will be little or no taxation within the bond incurred on its investments.
There are two major taxation benefits for the investor: firstly, up to 5% of the initial investment amount per annum can be drawn each year without liability to tax until a ‘chargeable event’ occurs. However, on one of these events, whether any further tax is due will depend on the investor’s tax position in that year. In essence, if an individual’s other taxable income is significantly below a higher rate tax threshold, there may be little or no tax due on part or all of the gain. As the 5% allowance is cumulative, this can be rolled up over the years for when it’s really needed, meaning further lump sums can be withdrawn.
Further, these investments can be flexible enough to provide extra benefits in terms of Inheritance Tax and trust planning.
As with all structures, there are issues however, including relative complexity and although flexible, the tax treatment can be onerous if a very large lump sum is needed.
One investment to rule them all?
Overall, what is hopefully clear is that there are a large number of investment structures that can be used to generate an income. Indeed, the above only scratches the surface. However, each comes with its own advantages and disadvantages.
Therefore, although there is no clear-cut winner the above also shows that by utilising an amalgam, and cherry-picking structures to suit a client’s objectives and needs, not only can an easy to understand, tax efficient portfolio be generated, you never know, that income stream might just start to flow after all.
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