FISCAL DRAG: When is the number not THE NUMBER

michaels

Jane Blogs worked and saved hard and retired at 55 in 2021.  She had lined up inflation linked pension (including state pension) so she had £50270 in real terms for the rest of her life.  Comfortable right?

She had not anticipated the freezing of tax allowances though, so will she really have her number to spend in real terms every year?

SO far the freeze in thresholds mean that her 50,270 gross / 42,730 net is now only worth 39,786 in 2021 money purchasing power terms, so about 3k / 7% less.  Belt already tightened, that long haul holiday is not strictly Europe only.

Come 2031 and assuming 3% inflation per annum between now and then and she is down to 38,222, 4.5k / 11% less.  Bang goes a new car every 5 years.

Lets assume the thresholds continue to be frozen.

By the time she is 70 it is 37,115, at 80 it is 35,335 and should she make it to 90 she will only be getting 34,011, 80% of her original income.

Not sure if other people are the same but I have done all my retirement modelling based on maintaining a constant real terms income including using annuities, index linked bonds, DB, state pension etc to manage the impact of inflation.

So perhaps all our THE NUMBER modelling is wrong and actually we need to work on needing a real terms gross income increasing by 1-2% per annum in order to make up for fiscal drag?

[As an aside, Jane will pay nominal 7.5k of tax in 2021 and 53k a year when she is 90]

michaels

Of course the above analysis is all wrong, in reality the situation is much worse - when she is 74 in 2040 (15 years time) her nominal income will go through 100k so we will have to start factoring in loss of personal allowance and additional rate tax.

kempiejon

Ah what the sensible Jane has done is make a prediction about tax rates, wrappers, allowances being fairly benign and while that's not unreasonable shows a trust in government that cannot be counted on long term. We're some uof us 30 years retired, look at the last 30 years of tax treatments.

One could model an income and investment path that has some slack in the number adding in a safety factor of say 12% more than needed which is for rainy days or unexpected spends, some of this can be redirected to more investments if the flow looks below what's needed.

singhini

I wouldn't say it was all wrong, I thought it was right, OP has identified the missing variable in almost all retirement planning models:

Tax thresholds do not rise with inflation, even when income does.

Your point amplifies the situation (which you correctly point out). Again your right, by 2040 it will go thought £100k (£105k i make it) and by 2056 (aged 90) will be £158k (30% real net income lost from 2021 baseline). 

kempiejon

michaels said:
Not sure if other people are the same but I have done all my retirement modelling based on maintaining a constant real terms income including using annuities, index linked bonds, DB, state pension etc to manage the impact of inflation.

Ah the feature of, annuities, IL, DB and state pension is they pay an inflated (potentially plus a bit in the SP for now) but fixed amount for life. I have invested and modelled on a growing income, my plan is majority global equities where I expect volatile but hope for above inflation returns with fixed income for a baseline.
The income part of my equity portfolio has been returning real plus a few percent for each year, the growth part also outstripping inflation.
I think one could be looking too simplistically by expecting a constant expenditure for all those perhaps 20+ years off the tools. Though exactly how to predict that is very specific and like much of the future unknowable.

sheenas

Maybe also consider inflation is based on a basket of items. Does a retired Jane purchase these items? Retirement also normally assumes the mortgage is paid (not part of inflation figure any more), but of course it might not be. 

SVaz

We were expecting at least a 2.5% rise in personal allowance  yearly from 2028- 2032 so it’s thrown a bit of a wobbler into our early retirement after carefully calculating our income for those years., especially if we get higher inflation

We will have to take more from ISA savings which means selling investments to preserve emergency cash.  Bloody aggravating. 

ClashCityRocker1

if she is earning £50K in real terms for life just means she'll be paying more tax on some of it doesn't it? So next year goes up to 51K she'll be taxed at 40% instead of 20% on about £1K of it. Of course she could put that £1K into a pension instead until she gets to £3600 in a few years time.

Cobbler_tone

We don't know what Jane's lifestyle is but unless she still has a mortgage and doesn't live in a mansion, I'd imagine she will be pretty comfortable for the rest of her life. If some survive on the state pension she must be laughing and would imagine she can have her new car every 5 years, if that is what floats her boat.

MeteredOut

SVaz said:

We were expecting at least a 2.5% rise in personal allowance  yearly from 2028- 2032 so it’s thrown a bit of a wobbler into our early retirement after carefully calculating our income for those years., especially if we get higher inflation

We will have to take more from ISA savings which means selling investments to preserve emergency cash.  Bloody aggravating. 

My spreadsheet model previously had tax thresholds held till 2030 (and had been since the middle of last year). Changing it to 2031 has not impacted things much. It also assumes future threshold increases at 1% below the model's inflation assumption (which is 3%).

michaels

Cobbler_tone said:

We don't know what Jane's lifestyle is but unless she still has a mortgage and doesn't live in a mansion, I'd imagine she will be pretty comfortable for the rest of her life. If some survive on the state pension she must be laughing and would imagine she can have her new car every 5 years, if that is what floats her boat.

50k was just as an example.  Even if it was 12.500 the same effect will manifest.

AFAIK the 'SWR' tools all work on what 'constant inflation adjusted income' could you safely take from a given pot size.  Thing is this constant inflation adjusted GROSS income is no longer in any way constant inflation adjusted spending power, in reality it it represents a slow (assuming low inflation) decline in spending power, and depending on real wage changes potentially an even quicker decline in lifestyle compared to the median.