Retirement planning gets weird quite quickly

What happened

I was playing with the retirement spreadsheet again this morning. Dangerous, I know. This time I was deliberately being optimistic and putting in some pretty healthy investment returns, just to see what happened if markets were unusually kind to us.

I compared two very different ways of funding exactly the same retirement. One was our current favourite idea, which is to use part of the pension to buy an annuity and create a chunk of guaranteed income every year. The other was much more aggressive: spend the defined-contribution pension first, and try to leave the ISAs alone for as long as possible so they can keep growing. I thought I knew what would happen. I assumed the DC-first version would get battered by tax and the annuity version would look much cleaner. Not quite.

In this particular test, retirement starts with roughly £391,000 in the DC pension and around £336,000 across the Cash and Stocks & Shares ISAs. I also gave the Stocks & Shares ISA a very optimistic 6% real annual return. This was definitely not meant to be a cautious forecast — I wanted to see what happened if investments behaved really well. Under the DC-first version, the pension gets used pretty aggressively while the ISA is mostly protected. Under the annuity version, we draw the pension down to around £200,000 and then use that to buy roughly £12,000 a year of guaranteed income. The remaining spending gaps are filled from the ISA. The surprising bit was just how close the DC-first version got to the annuity version over the long term. That made me stop and look properly at what was going on, because on the face of it the two approaches feel completely different. The tax side was stranger than I expected too. The DC-first version can create some fairly ugly tax bills at the start because the pension income is mine. I can’t simply split that income between me and Karen to make the tax nice and neat. But once that pension has gone, it has gone. From then on, much more of the spending comes from the ISA, and ISA withdrawals are tax free. The annuity route is almost the opposite. The annual income looks cleaner, but the annuity itself is taxable, and it keeps being taxable year after year. So you can end up with one strategy that pays more tax early, but another one that pays more tax over the whole retirement.

That was one of those moments where the spreadsheet made something obvious that really wasn’t obvious before.

What changed in how I judged it

But then you get to the bigger point: lower tax doesn’t automatically mean better.

The DC-first version looks great if the stock market behaves itself. In fact, that is partly why it works so well in the optimistic version. We are deliberately protecting the ISA and leaving a large amount of money invested for longer. But that is also the risk. If we were retired and the ISA dropped 25% or 30% during a nasty market crash, the spreadsheet might still say the plan was fine. I am not completely convinced I would feel fine. The annuity version is different. We hand over a big chunk of capital, so we lose some flexibility and we no longer have that £200,000 sitting there looking reassuring. But the income arrives anyway.

Markets can have a tantrum. The annuity still pays.

Add Karen’s Teacher’s Pension, the small DB pension and eventually the State Pensions, and quite a lot of our retirement income starts to become independent of what the markets are doing. That has a value which is surprisingly hard to capture in a spreadsheet.

This is probably the bit I keep coming back to. It is very easy to compare two retirement plans and ask which one is “best”, but I am increasingly convinced that is the wrong question.

One route might leave more capital available, pay less tax, and benefit more if markets do brilliantly. Another might provide more guaranteed income, reduce market risk, and make retirement psychologically easier.

Those things are not really measuring the same thing.

You can put tax into a spreadsheet. You can put investment growth into a spreadsheet. You can put ending balances into a spreadsheet. You can’t easily put “I slept perfectly well during a 30% market crash” into cell AJ42. I checked.

When I first started all this, I thought retirement planning was basically a case of finding the right calculator and answering one question: when can we retire? What I actually needed was a way of asking hundreds of slightly different questions. What if we use the ISA first? What if we use the pension first? What if we buy an annuity? What if markets are brilliant? What if they are awful? What happens to tax? What happens when the State Pensions start? What happens if certainty becomes more important to us than squeezing out the biggest possible final pot? That is why this stuff gets complicated so quickly. The annoying answer is that retirement planning is not one calculation. It is a pile of decisions interacting with each other.

For now, I still like the annuity version of our plan. Not because the spreadsheet says it “wins”. In fact, the spreadsheet has done almost the opposite. It has shown me that there are several perfectly plausible ways of doing this.

What I think I am paying for with the annuity is not really better returns.

It is certainty.

And the more I model the alternatives, the more I think that certainty may be worth paying for.

The question I’d ask myself now

Am I actually trying to maximise the final pot, minimise tax, or buy enough certainty that I can enjoy retirement without worrying about the markets?