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The pension fallacy (Part 3)

Is spending the kid's inheritance by living off your capital cheating? Or should you build an infinitely sustainable money making machine?
This is the third of what is starting to feel like a marathon series of posts about the fallacy of pensions. Surprisingly I haven't yet run out of things to say, nor tired of writing those things up, so the series continues.

Last time I left you pondering the injustice of having saved a bunch on money in a private pension account, only to be told by the government that you were too young to access it. Doesn't seem fair really.

Where does that leave you if you want to retire early?

Let’s say you don’t fancy suiting up, commuting, and slaving away in a job until you are aged 55, or 57, or whatever the arbitrary pension access age happens to be when you reach the point that you are ready to step off the hamster wheel.

I reached that point aged 39.

That was 16 years before the government feels I should be allowed to access any private pension funds.

That was 26 years before I would be eligible for an old age government pension.

That was a long time before the government feels I should be allowed to access any private pension funds.

Had I channelled all my savings and investments into tax advantaged pension accounts, then early retirement would have been a pipe dream. My funds would have been locked away in inaccessible pension accounts.

Using the £25,000 annual cost of living estimates discussed earlier, funding that 16 year gap between early retirement and pension accessibility would require a considerable sum to tide me over until pension age.

I would need approximately £400,000 (£25,000 x 16 years) in savings held outside of tax advantaged pension accounts. That number does not include housing costs or account for inflation.

Mind the gap?

Now this throws up an interesting philosophical question, how do you fill that gap?

According to Monevator’s most excellent analysis conceptually an ISA and a pension are exactly the same when it comes to tax treatments.

With ISAs you pay in after tax income, then (at present) the tax man keeps his grubby little fingers off any income or capital gains subsequently achieved within the wrapper. Hoorah for tax free investment returns!

There are no age limitations on touching ISA funds.

On the other hand pensions are populated using before tax income. Any income or capital gains earned within the pension are tax free. However the government picks the age from which you are able to touch the pension funds and, except for a one off 25% lump sum withdrawal, the tax man mugs you each time you withdraw from your pension.

Which option is best?

Well, like most things in the personal finance world, it depends.

Assuming your marginal tax rate remains the same before and after retirement, then in theory the tax treatment is exactly the same. You either pay your taxes on the way in, or you pay your taxes on the way out. The one constant is the tax man will definitely pick your pocket at some point.

However in reality tax rates tend to rise and fall with the economic cycle.

If the tax rates were lower when you put money into that ISA than they happen to be when you were looking to withdrawn from a pension, then you would likely be doing the victory dance while proclaiming yourself a prescient investment genius.

Were the tax rates to move in the other direction then you’d be excused for having the mother of all toddler tantrums.

Piss poor planning does not an emergency make

Conventional wisdom holds that many people will earn less in their retirement than they did while they were working.

Whether this is by design, or due to piss poor retirement planning, I’ve never been able to ascertain!

Certainly if I ended up in that kind of financial hole then my financial advisor would likely be on the receiving end of a well deserved punch in the face.

Either way, if income happens to be lower in retirement than during working life, then pension income may well be taxed at a lower marginal tax rate than a person was earning while contributing to their ISAs.

This probably isn’t much of a consolation to the pensioners queueing up outside their local Wetherspoons for Thursday curry club, because they can no longer being able to afford to eat at La Porte des Indes.

No longer being able to afford to eat at La Porte des Indes?

Decisions, decisions...

If you are anything like me, then you may have decided that early retirement was preferable to decades more soul destroying status update meetings, humouring gormless lackwit project managers, and hand holding indecisive yet self-important C-level executives who possess attention spans short than your average sugared up toddler.

The problem is the “early” part, which leaves a significant gap between the finishing up of selling off your life a day at a time and the commencement of your pension.

What would Chuck Norris do?

I once had a kind of annoying guy work for me, who used to answer such questions with one of his own: “what would Chuck Norris do?”.

what would Chuck Norris do?
According to IMDB Chuck Norris is 77, which meant he was getting his ass kicked by Bruce Lee in “The Way Of The Dragon” more than 45 years ago.

He still looked menacing the last time I saw him save the world in Expendables 2, but he obviously had some mobility problems given Sly Stallone gave him over watch duties with a sniper rifle while Bruce Willis and Arnold Schwarzenegger performed a ballet in one of those roller skate Smart cars (with machine guns).

Is there anything better than a 1980s action movie sequence?
Ok, so maybe that wasn’t much help... though you must admit it was a pretty cool nostalgia piece for those of us old enough to appreciate slightly crotchety 1980s action movie stars. If you don’t know who these guys are then you are not yet old enough to be considering early retirement!

What would I do?

My perspective differs somewhat from the conventional FIRE script.

The early retirement blogosphere would have you believe that you should aim to run down your nest egg throughout your retirement years.

The goal appears to be that the retiree should aim to expire at roughly the same time that their funds run out.

While this may be a noble ideal, I’m not so sure myself.

My year 7 music teacher once observed that I lacked any semblance of rhythm or timing, a fact that my kids would readily attest to whenever they suffer the misfortune of witnessing my “Dad dancing”.

Dad dancing for fun and profit
Therefore I must I respectfully disagree.

The prospect of outliving my savings doesn’t sit well with me. I don’t fancy having to resort to the government pension should my own pension planning fall short. In fact I don’t much fancy having to resort to the government pension at all… have you seen how little they pay old folks? I for one couldn’t live on that!

Don't leave it to your kids, they'll only fuck it up!

The authors of The Millionaire Next Door observed that one of the most effective ways to turn a large fortune into a small one is to inherit it.

I’m not convinced by this, I think the failing is largely in the parent’s education of their children more so than the children’s inability to effectively manage money.

You only learn to value money when you don't have much of your own, scarcity promotes evaluation of buying choices and consideration about the expendable effort required to accrue the funds needed to make a purchase. This is a scenario that is easy to create, regardless of how well off the parents may be!

Maybe I’m wrong on this, but I’d prefer to give my kids the benefit of the doubt and aim to leave them an inheritance rather than to piss it all away in a SKI (Spend the Kid’s Inheritance) frenzy. All things considered I’ll be too dead to care whether they live up to my expectations.

There are options, but not that many

To my simple mind wannabe early retirees have two options.
  1. Accumulate a finite bucket of wealth, then gradually dip into it to fund their remaining years. If they die before the bucket empties then they win. If not, then it sucks to be them.
  2. Construct a sustainable passive income generating machine. This throws off enough income to sustain the retiree throughout the early retirement adventures, their traditional retirement age “grey nomad” caravanning trips, and their late retirement nursing home care.
I must confess I much prefer option 2, though perhaps not the caravan part.

I would hate to think that I may run out of money.

I would hate to be a burden to my kids.

With option 2 I can aspire to being a dirty old man, my success independently quantifiable by the shortness of skirt worn by my nursing home nurses. Nurse Kiwi Steve, if you're reading this please do not feel obligated to wear a short skirt when next offering to give me a sponge bath... there are some experiences in life that are best left unrepeated!

With option 2 my kids would inherit the same self-perpetuating income generation machine. Inheritance taxes aside, if they fuck that up, it is on them.

So what?

I am a big believer in creating a sustainably replenishing money generating machine.

I think those who elect to live off their capital are short sighted and potentially cheating at this Financial Independence game we choose to play.

I will talk about how I have gone about constructing such a magic money making machine soon, but my next post will discuss why you should always "trust, but verify" any advice you receive.

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