It never rains but it pours. Not only has Stephen’s boiler given up the ghost, but his leaking roof is getting worse and it now needs replacing. With the worst of the winter rapidly approaching and the Daily Expresspredicting a very harsh one he needs £12k urgently.
Stephen receives a State pension of £7k a year and has a pension fund of £100k from which he currently draws £6,000 a year. Stephen’s wife, Helen, receives a State pension of £7.2k a year. They also have £1,500 held on deposit with a building society. How are Stephen and Helen going to finance these urgent outgoings?
With a combined income of £20.2k they would describe themselves as reasonably comfortable however they admit they would struggle to cope with a large increase in their outgoings. The boiler supplier offers a nothing to pay for 12 months credit deal, but if not repaid within that period an extortionate interest rate will apply the following three-year repayment period. They have credit cards but the interest rate is comparable with what the boiler finance scheme would charge.
At current rates a five-year personal bank loan for £12k would cost nearly £250 a month for five years. This is around 15% of their combined income and will have a serious impact on their living standards.
Why are we looking at finance schemes, credit cards and personal loans when Stephen has £100k in his pension pot? Why not pay the £12k from that?
Well, an additional £12k withdrawal will be taxed at the basic rate. He therefore needs to withdraw £15k to receive a net amount of £12k which would reduce his pension fund to £85,000. A regular £6k withdrawal from that is 7%, twice what is often regarded as the safe withdrawal rate for retirees in the UK. This means that in all probability his pension fund will expire before Stephen’s death. This is worrying; because Helen is five years’ younger than Stephen which means there is a high probability she will outlive Stephen for many years.
To protect his pension fund, Stephen could consider reducing his pension drawings by £250 a month. The same amount as the bank loan. This will have a similar impact on their living standards as taking out a Bank loan. But, what about using their housing wealth to overcome their short-term financing needs?
The alternatives here are often cited as downsizing; a retirement interest-only (RIO) mortgage; or equity release.
Downsizing is probably not available as a solution to this problem; it will involve large transaction costs (stamp duty, estate agent fees and professional fees). It would also take time to produce funds which are urgently needed. Downsizing, to be effective, needs plenty of planning. Rushing into buying a property because of financial pressures will often make true the saying, ‘Act in haste, repent at leisure’. If the house that is purchased does not make the occupants happy, those large transaction costs may soon be incurred again.
A RIO mortgage is probably not suitable for a £12k loan. Although the repayments may be low, I suspect Stephen and Helen may find the additional outgoing difficult to difficult to cope with.
Equity release drawdown may therefore be moved to the front of the solution queue. But, questions should be asked. For instance, why set up a facility that may not be used when the upfront costs of arranging may be disproportionately high? What do their children think of the proposal?
There is however something missing. If Stephen currently has £100k in a drawdown pension pot, what has happened to the tax-free cash sum he took when he retired? How much did he receive? £30k? Or was it as much as £50k? How was it used? To pay off debts when they entered retirement? Or has it just been spent over the period of their retirement to date?
These are very important questions. Opinion as to whether someone is financially comfortable depends upon their attitude to life. It does not mean that Stephen and Helen are living comfortably on their current income. They are already drawing down their pension faster than would normally be recommended, and I can tell you they had next to no debt when they retired.
As they have also drawn down their tax-free cash leaving just £1,500, their problem is not how to raise £12k for their immediate needs; it is how to finance their spending over the remainder of their retirement. This is an entirely different matter. They believe they can live off an income of £20.2k but in practice their spending is much higher. The need for advice is clear and obvious here – and there will be many people in similar situations all over the country. Advisers need to recognise the demand and ensure their services are in the shop window so that people like Stephen and Helen know exactly where they should be going to secure it.
Bob Champion is chairman of the Later Life Academy (LLA)