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Strategy for rising income in retirement?

Retirement | Annuities Helpful? 6

Asked by billymo, submitted 28 September 2012.

Open Quote Can I ask your opinion on the following idea to maximise the income from my upcoming pension fund.

1. Take 25% tax free lump sum and invest in equity income funds within an ISA.

2. Opt to receive a level annuity.

3. Construct an annual budget as if I had opted for an escalating annuity, linked to the RPI, and invest the balance in equity income funds again within an ISA.

4. Repeat for subsequent years, gradually increasing the annual budget in line with the RPI, and continue to invest the remaining cash in the equity income ISA.

End Quote

Answered by Justin on 01 October 2012

It sounds reasonable provided you're confident you can stick to your annual budget and are comfortable investing in stock markets.

For taxpayers, taking the 25% tax-free is generally a no-brainer, as it would otherwise be used to produce a taxable income.

Investing this money into equity income funds within an ISA will ensure the income generated is not taxable and does not count towards your increased age related income tax allowance (although the latter is being phased out by the Government in any case). But note, basic rate taxpayers don't save income tax on dividends within ISAs or pensions (blame Gordon Brown), as dividends are deemed to be paid net of basic rate tax which cannot be reclaimed - although higher and top rate taxpayers avoid any further tax in these wrappers.

Equity income fund dividend yields currently tend to be around 3-5% (net of basic rate tax), which is attractive in this low interest rate environment. However, bear in mind these things can change over time and if markets dive then the value of your ISA probably will too. On the plus side, dividends have a pretty good track record of keeping up with inflation, but I must stress this is over the longer term and short term dividend fluctuations or an inflationary spike could catch you out.

If there comes a time when the ISA income can't keep pace with your inflation-linked budget you'll have to consider either reducing your budget or dipping into ISA capital, neither especially pleasant.

You could take a look at the level vs index-linked pension calculator on our calculators page to get a feel for when the break-even point between the two types might be, although this assumes a constant rate of inflation which in real life willl undoubtedly vary.

Perhaps consider diversifying the ISA away from just equity income. For example, holding other assets such as fixed interest and property will reduce your reliance on the stock market for your strategy to work.

Alternatively, if your pension fund is large enough you might consider taking the 25% tax-free cash, leaving the balance invested and drawing an income (called an unsecured pension). You can read about the pros and cons of taking an unsecured pension on our annuities page.

Good luck.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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