How to create a retirement salary

The great thing about having a regular job is that you know that every month your employer will send you a set sum of money. Even if you spent that month on holiday or ill in bed, or whether you worked your socks off or took it easy, your salary will arrive in your bank account on a certain day with complete reliability.

Don’t we all want the same thing once we’re retired? To take the place of a normal salary, don’t we all want a retirement salary?

This isn’t the first time I’ve written about your retirement salary; in fact I once co-wrote a book with that very title. A few years have passed since then – years that have seen big changes in the investment landscape – so here is an updated look at the subject.

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The simplest solution: buy an annuity

If you want a retirement income that’s exactly like a salary, an annuity provides it. In exchange for a lump sum, an insurer will pay you a set amount every month until you die.

Of course, when we’re in employment we generally expect pay rises every year. You can get an annuity that offers this, although you will pay more for it. Some annuities offer fixed annual increases of say 3% while others will increase your ‘salary’ in line with inflation. Ideally you will choose one or the other because an income that’s fixed for life and never rises is a dangerous thing in times of inflation.

• Read: Is ‘financial repression’ coming? Here’s how to beat it

If you’re married you may want to consider a ‘joint life’ annuity, which will continue to pay your spouse after your own death. If you are worried that you may hand a large sum to an annuity company and die shortly afterwards, you can ask for a ‘guarantee’ period during which the annuity will pay out regardless.

Finally, when you are looking for annuity quotes, be sure to disclose any health conditions, because you will receive more income should you have a condition that would tend to reduce life expectancy.

The beauty of an annuity is that with one transaction your income needs are taken care of for the rest of your life. A big disadvantage is that the income disappears when you die (unless you have a guarantee) and there is nothing to leave to your family.

Either way, rises in interest rates over the past few years have given a huge boost to annuity incomes. For example, a couple both aged 65 could get an annual income of about £5,400 that rises by 3% each year by spending £100,000 on an annuity.¹

Peace of mind with more flexibility: the ‘blended’ approach

If keeping control of your pension savings or leaving money to your family is important to you but you still like the idea of a guaranteed income for life, one approach is to split your pension savings in two, then use one part to buy an annuity and leave the other part invested.

Some financial advisers suggest buying an annuity that will, in conjunction with other guaranteed sources of income such as the state pension and any final salary pensions, be enough to cover all your likely essential expenditure. Any money in your pension pot beyond that can be left there to grow, just as it has been up to that point, and can generate some income for you too. We discuss how such income can be generated in more detail below.

For more on the mix-and-match method, read our recently published article The benefits of a blended approach to annuities and drawdown.

Taking full control: income drawdown

If you avoid annuities entirely, you (or your adviser) will be responsible for managing your savings so as to generate a reliable and growing income. This is called ‘income drawdown’ as you are gradually drawing down the savings that you accumulated during your working life.

In terms of complexity and the amount of work you’ll need to do, drawdown is at the opposite end of the scale from an annuity. You’ll need to devise a plan that takes into account your income needs, the various risks (such as inflation and market setbacks) and minimising your tax bill. And these things will need to be kept under regular review.

In terms of practical steps, you’ll need to decide what assets to invest in, how much income to take each year and how to apportion that income between taxable pension income, the pension tax-free lump sum (which can be taken as a regular income) and your ISAs and savings. We’ll look at these aspects in turn.

Choosing investments

Here there is almost too much choice. We will try to simplify things as much as possible.

You might think that, when generating retirement income is your purpose, you have to choose income-generating assets. However, this is not automatically true: some advisers suggest that you invest in assets geared more to growth and simply ‘sell the growth’ to get your income.

In other words, if an investment gains 5% in a year, say, you sell 5% of your holding in that investment. The basis of this argument is that ‘total returns’ – capital gains plus income – are often higher from growth-orientated assets, so taking this approach could, over the long term, lead to a higher income (or more left over for your children).

The counter-argument against using growth assets and making regular sales from those assets is that in some years there may be no growth and may even be losses. Continuing to generate a set amount of income from asset sales when prices are falling is a good way to ruin your retirement, as you will be selling more of the assets to make the sum you need and whittling away your capital.

However, we can get round this problem if we keep enough cash aside in a ‘buffer’. This way, if your investments start to lose value, you stop making sales from them and take the income you need from your cash buffer instead. Ideally your buffer would be enough to cover several years of income. This approach has been advocated, in effect, by no less an authority than Warren Buffett.

Your next decision is whether to invest actively or passively. The latter is simpler; the ultimate in simplicity would be simply to buy a global tracker fund, which instantly gives you huge diversification. Our Select 50 list of recommended funds includes the Legal & General Global Equity Index Fund, which holds shares in 2,312 companies from around the world. One out-and-out growth fund among passive options is the Legal & General Global Technology Index Trust.

If you want the chance to outperform the market, you could buy a handful of actively managed funds. Again you could start with our Select 50, or use our fund selection tool. Popular choices among Fidelity customers include the Rathbone Global Opportunities Fund. Of course you could also opt for a mix of passive and active funds.

If you would prefer investments that produce income automatically, you will avoid the need to make regular partial sales of your assets (or will make smaller sales – see next section) and will therefore need a smaller cash buffer, although you should not dispense with one altogether, just in case there is another calamity along the lines of the pandemic and all investment assumptions are overturned. Your cash buffer is your ultimate safety net.

There is an enormous choice of income-generating investments and again you can take a passive or active approach. For passive funds even a simple FTSE 100 tracker such as the iShares Core FTSE 100 UCITS ETF from our Select 50 will, at current prices, produce a 3.2% yield (variable and not guaranteed), which you could top up with small regular sales from your portfolio.

The Vanguard FTSE 250 UCITS ETF, also on the Select 50, currently yields more at 3.8%. Passive funds that generate income from underlying assets beyond shares are also available and will diversify your income stream and therefore make it more resilient. One example is the Legal & General Emerging Markets Government Bond (Local Currency) Index Fund (6.1% yield).

Active choices abound too. Options from the Select 50 include the M&G Emerging Markets Bond Fund (7% yield), the International Public Partnerships investment trust (5.9% yield), the JPM Global High Yield Bond Fund (6.4% yield on a projected basis) and the M&G Corporate Bond Fund (4.3% yield).

Other popular choices among Fidelity customers include TwentyFour Income (10.2% yield) and City of London (4.4% yield), which are both investment trusts (funds quoted on the stock market), and the Artemis Global Income and Fidelity Global Dividend funds (2.3% and 2.4% yields respectively). But for maximum resilience of income look to diversify the underlying sources of income from your funds, with perhaps a mix of equity income, bonds, property and infrastructure. Or you could diversify your income sources with a multi-asset income fund such as Wise Multi-Asset Income, which yields 4.7% currently. Please note all yields quoted here are not guaranteed and will move up and down with the market.

• Read: Top 10 best-selling ISA and SIPP funds this year

Deciding how much to withdraw

This is a tangled question that has attracted much analysis and debate but defies a single answer. A lot depends on how long you’ll live and how the markets will perform during your retirement – things that you cannot know at the outset.

What we can say with great confidence is that if you limit your withdrawals to 4% of your savings pot in the first year of retirement and then increase them each year in line with inflation, you will not run out of money in at least the first 30 years of retirement. This was the conclusion of a comprehensive piece of research by an American financial adviser called William Bengen that gave rise to what is now known as the ‘4% rule’. In later work he has increased that figure to 4.7%.

In my book on the subject I suggested a variant, namely to take the ‘natural’ income from your investments (dividends and interest from your shares, funds, bonds or cash) and top it up by selling 1% of your assets each year. So if your investments naturally yielded 4%, your actual income would be 5% – which is of course 25% more. The idea was that such a slow rate of erosion of your capital would have little impact on the ability of the portfolio to generate income and, barring very bad market conditions, would probably be enough to sustain you indefinitely.

Whatever method you choose, keep your withdrawals and investment performance under review. Inflation in particular could upset your plans, as Mr Bengen argued in analysis he conducted for Fidelity International.

Optimising tax

Just when you thought the subject couldn’t possibly get more complex, along comes the British tax system to add another layer. Not thinking carefully about how much income to take from your various savings pots (ISAs, SIPPs etc) and at what times could, by boosting your tax bill needlessly, have the same effect on your income as a stock market crash.

There’s no single answer that will suit everyone in all circumstances but bear the following in mind.

The tax-free lump sum is priceless. If you take a little of it each month, as the rules allow you to do, you boost your withdrawals without running the risk that the extra income pushes you into another tax bracket. One strategy is to take taxable pension withdrawals up to the 20%, 40% or, if you’re very fortunate, the 45% tax threshold but take any extra from the tax-free lump sum. And you could do the same with money in your ISAs. There’s more on this subject in our article 3 steps to avoid higher-rate tax in retirement. In both cases, there is no extra tax to pay and no need to declare the withdrawals on your tax return.

Some savers will find this part of the retirement salary conundrum the hardest to crack and may wish to take advice from a professional (see below).

• Read: 5 good reasons to take your tax-free cash - and 5 bad ones

The later-life annuity option

This is a final possibility as you get older and perhaps less inclined to spend time monitoring and managing your retirement income. As you age, the amount you’ll get from an annuity will rise (because it will pay out for less time), so it’s worth keeping an eye on annuity rates (they fluctuate in line with the market in government bonds) and being prepared to buy if they look attractive.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in a SIPP and tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of financial adviser or an authorised financial adviser of your choice.