Pension Potluck: The SIPP Quest in a DB-Deprived Landscape

Too young for a Defined Benefit Pension, too old to work forever. How do I start thinking about my savings when the tax man lurks around in the shadows?

In the era of the Defined Benefit Pension, you didn’t need to worry about how much to save and into which pot. You simply worked and accrued an income that would be a fraction of your final salary for life. Nostalgia is often misplaced as the past is demonstrably worse than the present, but in the case of retirement planning, nostalgia is entirely justified. What’s worse is that the Defined Contribution (DC) universe that we’re left with is as convoluted as the DC Universe from the movies - the difference is I’m a fan of the movie one.

My DC universe was/is small pots from various employers invested in a mix match of generally high-fee pseudo-passive balanced funds. I have been successful in consolidating the majority of my funds into a single [very low fee] SIPP. There are more to go. I also have managed to save some money outside of the pension in ISAs and other accounts - this probably reflects sub-optimal pension contribution at the time. In my defence, it was [& is] boring to think about pensions, and getting to grips with the tax aspects has not exactly been fun. I have got to what I think is a good holding pattern for me until the rules change or a better retirement product springs into existence. Have I mentioned that Modern Tontines might very well be that product?

I have one (tiny) Defined Benefit Pension scheme, which I have just left alone. It took me an embarrassingly long time to have a picture of what my savings were for. I don’t pretend it is optimal, but it is relatively simple; you can read about it here:

The taxation rules for Defined Contribution Pensions in the UK are annoying. You can have part of your pension as a lump sum, which is tax-free, but the rest you’ll get taxed on as if it is income; so at the various marginal rates at the time. It’s a great asset for your beneficiaries until you are 75 and then a pretty average one after that. Additionally, there has been something called the lifetime allowance that introduced very high marginal tax rates for pensions over a certain threshold, recently set at £1,073,100. This caused me all sorts of gyrations as I attempted to factor it in. Fortunately, they seem to have half-scrapped it [for now].

As my previous post suggested, and without a competitive landscape for shared longevity products, I’ve decided I will try to keep my SIPP until I’m close to 75 and then take the lump sum and use the rest to buy an annuity. I made this decision based mainly on the fact that I like my beneficiaries and want to maximise the value of this asset as a possible bequest if I don’t make it to 75 [a form of life insurance¹], and partly because of the various pension contribution rules over the years, I have saved in vehicles outside the pension tax wrapper. 75 feels late to buy an annuity, but buying one at the same time as having life insurance seems illogical.

This decision, though, has ramifications. It means that my SIPP should be no more than a certain percentage of my savings if, as is likely, I outlive my usefulness at some point before I’m 70 [haven’t you already - ED]. I need to solve for that percentage.

This is not simple. The approach to solving this I’m going to take is to think about limits, i.e., how I might arrange things if I had excess savings. Scaling things back [to the more disappointing reality] after seems like it would be a simpler calculation.

Also, the tax-free lump sum amount² and the lifetime allowance suggest that there might be a hard limit to the amount I should invest in my SIPP. While the current government has removed the lifetime allowance, it strikes me that future governments could reinstate it, and I’m not sure they have removed it as an inheritance tax threshold. Why do they make it so complicated? I have at least five Governments to live through before I get to 75, and thinking about the number of possible changes and tax raids that could happen could make me lose interest in this exercise completely! The cartoon at the top of this post made me chuckle.

However, plodding on, my prior starting point was to invest as much as possible in my SIPP until there is a good chance that I have close to the lifetime allowance limit when I’m 75. Now they’ve scrapped but kept the tax-free lump sum, I’m going to have to update that.

Having thought about it for a while, I don’t think I will abandon the concept completely. I will assume that it still exists but that it will be scaled up by the Bank of England’s [current] target of 2% inflation a year. I’m almost 50, so I have roughly 25 years to go before the DC pension doesn’t contain the life insurance aspect, the point I’m planning to annuitise it. So, the old LTA of £1,073,100 becomes a new future LTA of £1,760,500 in 25 years. This feels very arbitrary, but the fact that there have been these types of taxes in the past suggests that I shouldn’t ignore it. The LTA really seems like it was a terrible policy that has lots of unintended consequences.

[this bit is very boring; you can skip it] The amount I’d need to invest in my SIPP to end up with my arbitrary £1,760,500 in 25 years is a guess, but there are ways of making it less of a finger in the air. If I assume the only asset is a risk-free one, then I just discount that amount back at current risk-free rates³. Using today’s risk-free OIS swap prices and a cool system that I have access to [CRZ pricer] gives me a figure of £756k. So, the risk-free price of £1,760,500 in exactly 25 years is £756k today [19/12/23].

To estimate what 75% of £1,760,500 would get me as an annuity - remember, I’m spending the other 25% in my early 70s- I need the insurance company rate at the time and my life expectancy. then, I can plug this into the annuity formula:

\(C = PV \times \frac{r}{1 - (1 + r)^{-T}}\)

“r” here will be the risk-free rate minus the insurer’s costs and profits, and T will be my life expectancy.

Using 3% and 12 years from 75 and using 75% of the future value of my SIPP (the amount I am devoting to an annuity), I get a nominal annuity of about 132k with the inflation-protected one, starting maybe 15k lower. In today’s terms, that’s 60% of that, which is the equivalent of a 2% inflation-protected after-tax income of about £55k a year today.

Assuming the tax-free lump sum has stayed at the nominal 268k [surely it would grow with inflation?] and I’ve decided to withdraw it over five years, that gives me about £54k a year tax-free and another about 34k of taxable income each year. In today's terms, that equates to an after-tax income of about £52k a year for those five years. Slightly more if the lump sum has increased. I’ve cut a few corners, but the ballpark numbers look about right.

Funding the years before I’m 70, I can use the same OIS curve to work out the cost of a £55k 2% inflation-adjusted amount from the age of 60 to 70. This figure is 445k.

[You can start reading again] So why did I do this? Well, simply to see what % I might need in my SIPP and outside it to create a constant standard of living from 60 on at the same time as being aware of the tax rules. This is the split I get for the pots I identified in the previous post:

This “limit” exercise has £1.3m in savings at the age of 50, getting ~£55k a year in today’s money from the age of 60. The Gilts and ISA numbers are split across two buckets, as I think the ISA annual contribution allowance [now £20k] could bite; the rule is to fill up on ISAs before buying Gilts.

It seems strange that in the DC universe, the risk of tax raids seems to imply that the best I should aim for from my pension is £55k in today’s terms from 70 years old (and that’s assuming the BoE do their job). £1.3m in savings at the age of 50 seems high, too. In the next post, I will look at a risk allocation framework and see if I can lower this investment amount for this outcome without sacrificing any utility.

It’s worth reiterating that this is probably far from optimal and that the DC environment that I’m left with is much worse than the DB environment of my parent’s generation or the Modern Tontine environment [MT universe?] that we’ll get to for my children's generation [with your help we might get there sooner]. More on that in the post after next. In the meantime, please share this article and help this campaign get some traction. As always, comments are open to everyone, and I’d love to hear from you.

Financial Advice Disclaimer

Please note that the content on this blog is created for entertainment and discussion purposes only. It represents my personal viewpoints and should not be taken as professional financial advice of any kind. While I have tried to ensure the data is accurate, I make absolutely no claim that it is. The insights and opinions shared here are unique to my own experiences and are not intended to serve as a guide or recommendation for financial decision-making. This blog is not a substitute for professional financial advice, and readers should consult with a qualified financial advisor for guidance specific to their situation. I accept no liability for any outcomes resulting from the use of the information provided here.

1. I think that this Life Insurance Policy embedded in a DC pension pot because of IHT rules is equivalent to a £500,000 20-year Term Life Insurance policy bought at 55 [assuming the pension is sized as discussed]. The current quote for this is about £250 a month, and that would come out of net salary. Grossed up, that could be £420 a month into my Pension [40% taxpayer]. £420 a month invested for 20 years in a “model portfolio” [see the next post] has the simulated return distribution shown in the chart [assume $ = £] with a median value of £182k. Keeping the SIPP until 75 because of the Tax break does seem to be encouraged by this tax perk alone.

2. The Government has kept the “lump sum” limit at 25% of 1,073,100 = £268,275 or 25% of your SIPP value at the point that you take the “lump sum”, whichever is smaller.

3. I get to put off readers of this blog by putting in my favourite formula, which is the discount function:

\(D(t) = e^{-\int_{0}^{t} r(t) \, dt} \)

One over e to the power of the area under the function that describes the term structure of interest rates. I will do a geeky post on why you should think about interest rate risk in this way at some point. You can use e^-rt in the meantime.