How to avoid a disjointed financial plan
The benefits of a holistic strategy
How to avoid a disjointed financial plan
When your finances are aligned under one holistic plan, you benefit from a more strategic overview which also incorporates key life events
Many people might come to a financial adviser to solve a specific financial problem, but don’t take the extra step of integrating the solution into a wider financial plan.
For instance, perhaps you approach a professional for help with life insurance after taking out a mortgage.
Or you might seek financial advice following the birth of your first child. However, the matter of your pension, investments and estate plan are set to the side for now.
After all, those all feel far away into the future...
Exploring the benefits of a holistic financial plan
- A holistic financial plan knits together the various strands of your wealth and finances
- It aligns your different priorities under one common goal
- It avoids the pitfalls that come with addressing financial issues reactively, or in isolation from one another
...yet there are great benefits to creating a “holistic” financial plan.
It brings together all of the various strands of your wealth and finances to pursue a common goal - avoiding the waste that comes from disjointedness.
A lifetime plan
A “holistic” financial plan is a process that maps out all the aspects of your likely financial future - outlining important milestones and life events such as getting married, having children, paying off your mortgage, retiring and more.
Rather than addressing each issue reactively, as they come (by which point a lot of saving potential might be lost), a holistic approach allows you to lay out a road map which unites each one towards your financial goals - both short and long term.
Of course, no one can predict the future and it’s possible that many of these “milestones” may not happen to you (e.g. owning your own home or getting married).
Yet a lifetime plan still holds great value by also enabling you to pursue viable, desirable “backup plans” if your original plan doesn’t happen.
For instance, perhaps you hope to have children one day, so, in your 20s and 30s, you start building a separate savings pot for this (e.g. to help with future university fees or a house deposit when they are older).
However, if you never end up having children, then the plan wasn’t a waste. You still have a pot of investments to commit to something else you care about, such as setting up your own business or retraining for a new field of work.
The danger of not engaging in this kind of long-term, holistic financial planning is that it can lead you into problems later. After all, focusing on financial decisions one at a time, in isolation, can lead to a failure to consider how each decision might affect the others.
For instance, suppose you are now in your 40s and one of your goals is to retire at 55 (or 57, from 2028) and travel the world with your significant other. What if you are currently in a final salary pension scheme which could make this difficult to achieve?
One option might be to build up a separate private pension pot (e.g a SIPP) with more flexibility. But how might this affect your other hopes and goals - such as your ability to make overpayments on your mortgage (in order to pay it off early). Or, if you’re looking at things from the other side, how might your goal to repay your mortgage early affect your retirement plans?
Disjointed financial planning & waste
You also need to think about the tax planning implications of these decisions - both short and longer term.
For instance, in 2020-21 the Higher Rate on income tax in England is 40% on earnings between £50,001 to £150,000 (assuming you have the full £12,500 personal allowance).*
So, suppose your salary is £90,000 and you have two goals - repaying your mortgage early and retiring one day at 55 (or 57, as noted above). How do you decide how much to commit towards each goal? Without considering how taxes feature in the matter, you potentially stand to waste money which may otherwise have moved you closer towards your goals.
Bear in mind the current rules about tax relief on pension contributions: at the time of writing, Higher Rate taxpayers receive 40% relief. So, suppose you could afford to contribute £30,000 out of your £90,000 salary towards your pension each year. 40% relief on this amount adds up to £12,000 which goes into your nest egg.
Had you otherwise put all of this towards overpaying your mortgage, the £12,000 would have gone to the taxman instead.
*Please be aware that you will lose your personal allowance on a 2 for 1 basis on earnings over £100,000.
Of course, this doesn’t mean that it always makes sense - from a tax perspective - to increase pension contributions rather than overpay your mortgage. Yet it does illustrate the importance of not simply considering financial issues in isolation (e.g. retiring at 55/57 or overpaying a mortgage early), but rather crafting a holistic plan that avoids disjointedness.
Mitigating inheritance tax
Perhaps one of the major benefits of this approach is that, ultimately, it could help you pass on more wealth to your loved ones or chosen beneficiaries in the future as an inheritance.
In 2020-21, for instance, the inheritance tax (IHT) threshold is 40% on the value of your estate over £325,000 but certain assets are excluded from this under current rules (e.g. your defined contribution pensions), and also strategies exist to mitigate unnecessary IHT on others - such as making annual gifts or setting up an appropriate trust.
Nil rate bands can be passed between spouses on first death and therefore the basic tax-free threshold available when a wife, husband or civil partner dies can be as much as £650,000 if none of the £325,000 threshold was used when the first of the couple died.
You also need to take into account the residence nil rate band (£175,000 each for 2020/21) which applies when a main residence is passed on death to direct descendants, such as a child or grandchild. There will be a tapered withdrawal of the additional residence nil-rate band for estates with a net value of more than £2m. This will be at a withdrawal rate of £1 for every £2 over this threshold.
Quite often, to craft a holistic financial plan it makes sense to start at the end - e.g. your estate plan - and work backwards to your most immediate financial goals (e.g. establishing an emergency fund). After all, having a clear idea of what you want out of the whole of life can help you make wiser decisions about how to deal with your wealth and finances in the here and now.
Please note that this is based on current tax allowances which can change.
The article is for information purposes only and should not be construed as advice.
Is it time to update the 4% pension rule?
Why a bespoke plan could be considered instead
Is it time to update the 4% pension rule?
The problems with the 4% rule - and why a bespoke plan could be considered instead
The “4% Rule” within financial planning circles usually refers to the idea that you can safely take 4% out of your pension each year to live comfortably and sustainably. It has been popular since at least the 1990s when it was conceived, but has gained more attention in recent years due to rising young YouTube stars in the modern FIRE movement (i.e. financial independence; retire early).
Certainly, one of the attractions of the 4% is that it refines a complex problem - i.e. how to ensure you have enough money in retirement - down to a simple rule which is easy for people to understand.
However, as financial planners our role is to bring working solutions to our clients, not just those which are easy to grasp. Whilst the 4% Rule holds certain strengths and might still be suitable for specific situations and financial goals, this article highlights why it presents large problems in many cases which should lead individuals to consider crafting their own bespoke retirement plan rather than relying on a universal rule.
The 4% Rule: the power of an idea
Human beings seem to naturally be attracted to simple-sounding solutions to difficult issues. Politics is rife with examples. One might arguably point to the right, - such as President Trump’s policy to “build a wall” to solve illegal immigration from Mexico - or to the left - such as Labour’s proposal to re-nationalise certain industries in the 2019 general election (although admittedly proponents would argue such solutions were unfeasible).
Similarly, people can be quickly drawn to quick, easy-sounding solutions to difficult financial problems which later land them in trouble. Indeed, this is arguably why many people fall for pension scams - such as promises by a cold caller that he/she can help you access your pot before the age of 55.
The 4% is certainly not maliciously intended, and it gains further power due to its academic underpinning. In 1994, US financial planner William Bengen put forth the idea in a paper using historical simulations. Taking stock and bond data in the US over a 5-year period, Bengen concluded that a “Safe Withdrawal Rate” from a typical retirement portfolio was 4% and that this should enable most people to live on their retirement savings and investments for a 30-year period. The idea was neat, attractive and quickly caught attention - living on to this day in 2020.
Bursting the bubble with further study
As is often the case in history, popular ideas can be shown to be lacking when individuals have the boldness to challenge their central claims. For the 4% Rule, this happened when Wade Pfau tried to apply Bengen’s research to a wider context to see if the Safe Withdrawal Rate applied in other countries and markets. He collated 109 years of financial market data (1900-2008) and looked at 17 developed market economies using domestic currencies and asset classes. The results were interesting. Pfau concluded that, in the UK, even with the best foresight and “perfect blend” of bonds and equities, a maximum Safe Withdrawal Rate could be placed at 3.77%. Only if the client accepted a 10% likelihood of “failure” (i.e. running out of money in retirement) did the percentage rise to 4.17%. The failure rate then skyrocketed to 27.5% when the withdrawal rate was raised to 5%.
The picture becomes even more bleak when you consider that Pfau’s study didn’t factor in the impact of fees or fund charges which anyone looking to take an income from their pension savings will have to consider.
"The study didn’t factor in the impact of fees or fund charges which anyone looking to take an income from their pension savings will have to consider"
An alternative approach?
If people can’t rely on the 4% Rule, then is there another rule which might suit better - maybe at a lower Safe Withdrawal Rate?
Certainly, the Financial Conduct Authority sees value in offering such “rules of thumb” to assist UK consumers in their decision-making - setting up the Financial Advice Working Group in 2019 for this very purpose. Taking this into account along with the reality that each client’s situation and goals are unique, here is one alternative to consider for those looking to retire early:
Higher equity weights within a retirement portfolio (i.e. a more aggressive stock allocation) might allow for more sustainable income over a 30+ year retirement period. However, such individuals looking at a longer retirement horizon should seek professional financial advice to ensure they understand the higher risks involved with a 60%, 70% or higher equity weight.
One of the central issues to consider here is the fact that people are living longer. Bengen’s 4% was developed in the 1990s when life expectancy for men and women was lower, and also the period of study (i.e. 1900-2008) concerned lower expectancy still. In 2020, an individual might be facing a 40+ year retirement or longer, rather than the 30 years covered in his study where a 50-50 split between stocks and bonds was used in the portfolios for the simulation.
What does all of this amount to?
In short, we can probably safely say that:
- The 4% Rule can be useful for certain people, although its utility has decreased as average life expectancy has risen.
- The 4% Rule becomes less relevant for those looking to retire early.
- Increasing stock weight within a portfolio might support a lower Safe Withdrawal Rate (e.g. 3%-3.5%) based on certain historical data.
- However, you should consider discussing your case with a financial adviser before making any big decisions.
- Remember, past performance does not guarantee future results and you may get back less than you originally invested.