Mind the gap: how to retire before State Pension age

The FIRE movement is one of the internet’s stranger subcultures. Standing for ‘financial independence, retire early’, its acolytes aggressively save money in order to quit work in their thirties or forties. Fancy living off rice and beans for a few years? Or sleeping in a van? This movement could be for you.

I didn’t think so.

Many of us want to retire a bit early though, whether it is to spend more time with family or to travel the world. Even this is not an easy feat. Although you can typically access private pensions from age 55, rising to 57 in 2028, the State Pension doesn’t kick in for another decade - and it is slipping further out of reach. Currently set at 66, State Pension age will gradually increase to 67 by early 2028 and is due to hit 68 by 2046. Further, or faster, hikes have not been ruled out.

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A 55-year-old retiring today must sustain themselves for 12 years, therefore, before government support arrives. That equates to £170,000 of State Pension income, assuming the triple lock survives.

It is easy to dismiss the State Pension. Currently worth around £12,548 a year, people often complain that it is not enough to live on, or that it is less generous than support offered by other countries. Yet it remains the bedrock of most people’s retirement finances. Even a ‘comfortable’ retiree will get more than a fifth of their income from this source, according to new figures from Pensions UK.¹

• Read more: Why you don’t get the full State Pension

So how do you bridge the gap between quitting work and becoming a fully-fledged OAP?

1. Prioritise your pension in the run-up to retirement

In order to retire early, you need to save a lot of money - and where you store your savings can make that job easier or harder.

The benefits of paying into a pension when you are young are well known (to clarify, I’m talking about defined contribution pensions here). You have time on your side, meaning compound growth can supercharge your wealth. However, it can also be sensible to funnel funds into a pension in the later stages of your career.

The reason for this is tax relief.

When you contribute to a pension, money you would normally pay as income tax is added to your retirement pot instead. This can be done automatically in many work schemes. In others, only basic rate relief is added automatically, with any extra due claimed through self-assessment. You pay income tax when you eventually withdraw the money, but not on all of it: most people can take a quarter of their pension completely tax-free.

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The benefits are even greater if you drop down a tax band in retirement. For example, if you receive higher rate tax relief on your contributions but only pay basic rate tax on your withdrawals.

Let’s take an example.

• A higher rate taxpayer contributes £10,000 to her pension. £6,000 comes from her own pocket and £4,000 is tax relief.
• In retirement, she withdraws the money as a basic rate taxpayer. £2,500 (25%) is tax-free and the remaining £7,500 is taxed at 20%.
• In total, she receives £8,500 from a contribution that cost her £6,000.

In essence, the last few years of work - when you might have more spare cash to play with - are a great opportunity to convert highly taxed earnings into more lightly taxed retirement income.

There are a few caveats. First, the amount of cash you can take tax-free is not limitless. It is currently capped at £268,275. Second, the maximum most people can add to their pension (including personal contributions, tax relief, and employer contributions) is £60,000 a year or 100% of your earnings - whichever is lower. This is known as your annual allowance. Finally, it is important to note that pensions are less flexible than other tax efficient accounts such as ISAs.

If you’ve been neglecting your pension of late, don’t panic: ‘carry forward’ rules could help. These allow you to add unused annual allowance from the previous three tax years to your current year’s allowance. There are lots of conditions, however, so it requires careful planning.

• Read more: Could you have up to £20k more carry forward this tax year?

2. Combine tax perks

When you retire early, you want to squeeze as much out of your savings as possible. In Step 1, we discussed tax-free cash. However, there are other forms of tax relief too - and they can be most powerful when used in conjunction with one another.

There is a strong temptation to grab your tax-free cash when you retire. Maybe you want to live off it until you qualify for the State Pension, and plan to leave the rest of your pot untouched. Doing so can lead to a higher tax bill in the long run, however.

• Read more: The best (and worst) ways to take your tax-free cash

This is because, each year, most people get a personal allowance of £12,570. This is the amount you can earn without paying any income tax. If you subsist solely on tax-free cash, you are not making any use of this valuable allowance. The same logic applies to ISAs. While withdrawals are tax-free, by relying exclusively on ISA income you leave tax relief on the table.

It might instead be wiser to take a combination of tax-free cash and taxable income. (This is far less relevant once you hit your late sixties, as your personal allowance will be taken up by the State Pension.)

“We do this with clients a lot, particularly with those not quite yet at State Pension age,” says Charlie Nichol, an associate director in Fidelity's financial advice team. “It’s sensible to make use of your personal allowance, as if you don’t use it you lose it.”

It could also help avoid a nasty shock later in retirement, when withdrawals that were once tax-free suddenly push you into 20%, 40% or even 45% tax bands.

3. Consider a fixed term annuity

One of the scary things about retiring before State Pension age is the prospect of several years with no guaranteed income. If you only have a defined contribution pension, you are reliant on a pot of investments which can rise and fall.

One way around this is to buy an annuity.

Annuities typically involve handing over your retirement savings to an insurance company, in exchange for income for life. You can breathe easy knowing you have steady payments coming in, but the lump sum is no longer yours - and your loved ones won’t necessarily inherit it.

Recently, however, a different kind of product has been attracting a lot of interest: fixed term annuities. These guarantee income for a set period of time, with the option to get a lump sum back when the term ends. They act as a potential State Pension stopgap.

• Read more: The benefits of a blended approach to annuities and drawdown

Imagine you are 60 and have a £500,000 pension. You would like to use this to generate an income for five years, before receiving the sum back in full. According to the government’s comparison site, a good deal would guarantee you monthly income of about £2,000 a month.²

The fixed term route has become far more popular in recent years, according to financial advisers at Fidelity. This is because annuity rates have been rising, buoyed up by higher interest rates. Economic factors only count for so much, however. Annuity rates also depend heavily on your age and health. A healthy 57-year-old will get a worse rate than a 64-year-old with a heart condition.

Whatever your age, though, fixed term annuities are a good way to avoid sequencing risk. This refers to the danger that two people can quit work with the same amount of savings, and earn the same average return over time, but have very different outcomes because one of them experiences a market downturn early in retirement.

The chart below illustrates this using actual market data from the period between the end of 2005 and March this year. The blue line shows the significant impact of the global financial crisis: the retiree's portfolio suffered substantial losses early on, even though markets later recovered strongly.

If the order of those returns is reversed - so that the market crash occurs near the end of retirement instead of the beginning - the retiree finishes with a much larger portfolio balance.

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 pension or ISA 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). 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 Fidelity’s advisers or an authorised financial adviser of your choice.