The Ruthlessly Rational Strategy to Secure Your Retirement
Three months ago I was speaking with a new client of mine who needed to re-fix his mortgage. He was looking at his options and he said, "Jerry, what is the most ruthlessly rational strategy that I could follow that would put me in the best position at retirement?" I showed him that if he used his pension as a vehicle to pay off his mortgage, he could be even with the most conservative of estimates, a hundred and twenty thousand pounds better off at retirement. He was shocked and he said, “Why isn't everybody doing this?"
Although this strategy is the rational thing to do, it doesn't mean it's the right thing for everyone. I'm going to take you through this strategy step by step to show you why it's so effective but also why you may not want to do it so that you can decide whether it's right for you.
A Personalized Approach to Mortgage Management and Financial Independence
We all have attitudes to debt. Being debt-free, which makes deciding when, how, or if to pay off our mortgage a highly personal decision, but before you decide that debt is the devil or to get mortgaged up to the hilt, you first need to understand the facts. I can't speak to your own attitudes or personal situation, but I can show you the strategies that have worked for others so that you can decide whether they'll work for you. Let me start by giving you some more context about this client. When we met, he was 40 years old and had previously been aggressively overpaying his mortgage.
He had an outstanding balance of 150k with 15 years left on the term, and he was looking for a new fixed rate. He had previously been focused on getting debt free as fast as he could because he thought that that is what would help him to feel financially secure. However, after asking him a couple of questions and getting him to zoom out a bit, it transpired that what he really cared about was getting to a point of financial Independence and being able to retire with confidence, and he was open to exploring whatever route would get him there.
So he asked me, "What is the most rational strategy that I could follow that would give me the best chances of retiring with a lifestyle that I want?" I showed him this pension strategy that I'm about to show you in this article. But before we get stuck into this, I want to give you a quick one-minute reminder of how pensions work. I am talking specifically about Defined contribution pensions. These are the most common type of pension that most people have through work, and there are two ways that you can put money into a pension. It's either by sacrificing some of your gross salary into it, which avoids income tax and National Insurance, or by paying cash that you've already paid tax on into the pension, in which case the government gives you income tax relief. So it's as if you paid no tax at all. Once money is inside the pension, it then gets invested and grows free of income and capital gains tax. The only downside is that you cannot take anything out of it until your 55th birthday. However, that limit is set to increase to 57 from 2028, and it could go even higher in the future. When you do get access, you can draw 25% of the value as a tax-free lump sum, and the other 75% can be drawn down when you need it. It is taxed as income; you can either take your tax-free cash as a lump sum or in smaller chunks alongside the taxable part. If you decided to take 20K out of your pension, 25% of that would be tax-free, whilst the other 15K would be taxed as income, and if you didn't earn anything else in that year, you would only end up paying 486 pounds in tax based on today's rates.
Maximizing Pension Benefits for Long-Term Financial Growth
The tax breaks on pensions are so generous that there is actually a limit to how much you can benefit from them. This is known as the lifetime allowance and is currently set at one million and seventy thousand pounds, which we'll cover in more detail later on. So back to our example, I wanted to show my clients two different strategies that he could follow from this point to pay off his mortgage. The first was simply continuing on with his repayment mortgage, re-fixing the rates every three to five years until he's finally paid it off. The second is getting an interest-only mortgage, which has lower monthly payments, diverting that cash he saves into a pension, and then eventually using that pension to pay off the mortgage. To compare these two strategies, we're going to need to make some assumptions. Firstly, what is the average interest rate on the mortgage likely to be over the next 15 years? For this, I assumed four percent, which was above the rates that we were looking at at the time and is still above the long-term expectations now.
With this, his monthly payments with a repayment mortgage would be 1109 pounds, and you can see here how he would slowly pay off the balance over 15 years, whilst with an interest-only mortgage, his monthly payments would only be 500 pounds, which would free up cash of 609 pounds per month or 7,308 pounds per year, which he could instead pay into his pension or even better he could speak to his employer and sacrifice that portion of his salary into his workplace pension so that he would be saving both on income tax and national insurance tax.
And given that he was a higher rate taxpayer, that would result in an additional 12,300 pounds going into his pension each year. At this point, we need to make another assumption: what investment growth might he get on his pension over the next 15 years? He's a high-risk investor, so he's comfortable investing in 100% stocks, but again, let's be conservative and assume a five percent average annual return, that's just one percent above the rate of his mortgage. And if he carried on with his strategy, his pension would be projected to grow over the following 15 years to 291,000 pounds, which sounds pretty good, right? The only problem is that he can't access his pension until 57 at the earliest, which is not that big of a problem because we can just extend the term of his mortgage. Again, let's be conservative, though, and assume that the pension age changes again, and he won't actually get access to it until he's 58.
Assessing the Impact of Mortgage Repayment and Pension Utilization
I'd also assume that over these years, he's continuing to work, so he's paying the interest and also continuing to contribute to his pension as he did before, so that by the time he gets to 58, his pension will be worth 376,000 pounds. At this point, he could use his pension to pay off his mortgage if he wanted to. He could start by taking his 25% tax-free lump sum, which is worth 94,000 pounds, whilst the remaining 56 grand is going to have to come from the taxable part of his pension. Again, let's assume the worst and that he draws this out as one lump sum and has to pay 40% tax on the entire withdrawal, which would result in 37,000 pounds of tax and 187,000 pounds being withdrawn from the pension in total to repay the entire loan, which is not very tax efficient, but it would still leave him with 198k within the pension.
To be fair, we also need to recognize that with the repayment strategy, he would have already paid off his mortgage by 55, which would free up 1,100 pounds of monthly cash flow that he could then start putting into his pension. After tax relief, that would equate to 22,000 pounds per year going into his pension, and after three years, that would have grown to seventy thousand pounds. So there we have it, at the point of retirement, he is sitting there with his mortgage completely paid off, but he has an additional 120,000 pounds in his pension. As you can imagine, my client was pretty shocked by this, but he asked, what if our assumptions are wrong? At what point does this strategy fall apart? Well, firstly, the assumptions that we've used are pretty conservative as it is, but let's do that, let's push this and see when it breaks.
Firstly, what if the average interest rate over the next 17 years is higher than we expected? Well, if interest rates averaged five percent, so the exact same return as the pension, he'd still end up 82,000 pounds better off, which is really interesting. You're getting the same effective rate inside the pension as you would by paying off the mortgage, but it's the tax relief that you get on the pension that still leaves you way out in front. And if interest rates average six percent, he would still be 43,000 pounds better off, and if they went to seven percent, he would just break even.
Exploring Tax-Efficient Pension Strategies and Mortgage Repayment Options
So finally, what if he was a basic rate taxpayer? In this scenario, he'd be getting less tax relief on the way into the pension, but he would still be sixty thousand pounds better off overall, and again, that's assuming he pays 40% tax on the entire taxable withdrawal that's 47 grand in, so you can see that on the downside, this is a pretty robust strategy, but on the upside, there are lots of ways that this could be done more efficiently.
As he is voluntarily sacrificing additional salary into his pension, his employer will also be saving on National Insurance tax that they would otherwise have had to have paid. As such, his company may be willing to pay that tax saving into his pension. With this, he'd be projected to be a hundred and sixty thousand pounds better off at retirement. Secondly, because we've assumed that he draws down a big lump sum from his pension in one tax year. This is highly tax inefficient, whereas paying 37,000 pounds in tax, whilst a much more sensible approach would be to draw it down over several tax years to minimize tax and leave as much in the pension as possible.
We've also assumed a very conservative investment growth rate of five percent, but if he actually achieved a higher return of say eight percent, well that's when this goes absolutely nuts. There are probably some of you thinking why bother paying off the mortgage at all when you can just draw down enough income from the pension to cover the interest payments whilst keeping as much as you can inside the tax-free and growth environment of the pension so that it can just keep on growing into the future. This is a totally valid strategy and can be especially effective if you're planning to downsize at some point in the future anyway, but there is a chance that this strategy could fulfill of its own success. Remember that pensions have a lifetime allowance limit which is currently one million and seventy thousand pounds and Frozen until 2025.
Balancing Mortgage Repayment and Pension Strategies
After which it's projected to rise in line with inflation that is unless Mr. Hunt has anything to do with it in which case it will probably be frozen for the next hundred years. Sorry, I digress, but again, let's make a conservative assumption and assume that the LTA only grows at two percent a year from 2025. In this example, as you can see here, we're still not getting anywhere near that limit, but we also need to remember that these pension contributions we are suggesting are on top of the default contributions he is already paying in. With this client, this still wasn't likely to be a problem as like most 40 year olds, his pension was pretty unloved up until this point, but this does highlight why it's so important to do these calculations based on your own individual circumstances before you decide what is right for you.
If your circumstances are vastly different to the ones that we've been looking at here or if you have some other idea of how we could stress test this strategy, please do leave me a comment down below, and I'll let you know how this affects things. So clearly, this looks like a highly effective route to financial independence, which led my client to say, "Why isn't everybody doing this?" Well, even if this is the most rational strategy, it doesn't mean that it's a right strategy for everyone. Firstly, if having debt hanging over your head makes you feel uneasy, then you should not prolong that feeling for any longer than you have to. Perhaps the feeling that comes with being debt free is worth sacrificing that additional return. However, you can only ask that question if you know the size of the return that you might be sacrificing, which could be as we've seen quite a lot.
Also Read : How Do Interest Rates Affect Your Mortgage and Monthly Payment?
Secondly, the strategy that I've showed you here, where we're using an interest-only mortgage and then funneling all of the additional cash into the pension is the most extreme version of this strategy, but you could always do a bit of both. Instead, you could keep your repayment mortgage but extend the term beyond retirement, which would reduce your monthly payments and free up cash that you could divert to your pension. The risk here is that you don't have the financial discipline to invest that spare cash and instead end up spending it, which is why I suggest that you instead save via salary sacrifice so you never see that cash in the first place. You could also use some of that spare cash to invest in an Isa as well as a pension. It's less tax efficient but more flexible, allowing you to get access to it earlier if you really need it.
Leveraging ISAs and Pensions for Retirement Planning
Like in this example, if the client had wanted to retire at 55, we could have instead directed some of that cash into an Isa to help cover those mortgage payments until he turned 58. And if you have money in an Isa but realize as you get closer to retirement that you're probably not actually going to need this before you can access your pension, you can always use the cash within your Isa to then make larger pension contributions right before you retire.
Whatever strategy you decide on, the thing that I want you to take away from this is just how epic pensions are for building wealth. So even if you do decide to stick with your current mortgage, try to use your pension as much as you can. Now you might be thinking, my pension hasn't returned anywhere near eight percent per year or even five percent per year. Well, your pension is not going to perform well if it is not invested properly, which is why you need to keep glued to Mortgage GIG where I teach you everything you need to know about Mortgages.