Income, spending and debt

In a simple world, during our working lives we receive income as a result of our endeavours, from which we spend and put aside any remaining surplus to save for the future. We take on debt to smooth the strain on our income when large purchases occur, for example, a home improvement.

Related topics:  Retirement
Bob Champion
27th September 2016
Bob Champion, LLA, Later Life Academy
"Currently the economic environment mean, it has become more a question of, ‘Can I afford to retire?’ instead of ‘I will retire at a predetermined age’."

Servicing and repaying debt reduces the available surpluses to save for the future. However, this is not always the case. If the loan was used to buy a marketable asset then capital repayments could be seen as savings. If the asset has a value that will appreciate and offers a life necessity, for example, somewhere to live then borrowing to acquire that asset could be seen to be good financial management even if it restricts the amount available for more conventional savings.

On the other hand, if borrowing is to acquire an asset that will depreciate by 50% over three years and will provide little more than an alternative product that is much cheaper, then the quality of the financial management becomes questionable, particularly if the debt is restricting the amount available for other savings.  

While working, there are invisible contributions towards wealth creation. These include National Insurance Contributions, (the value of an £8k per annum state pension on current annuity rates is close to £300k), employer pension contributions and tax relief on pension contributions.

Currently the economic environment mean, it has become more a question of, ‘Can I afford to retire?’ instead of ‘I will retire at a predetermined age’. The answer to the affordability question is determined by the amount of wealth accumulated.

The ability to accumulate wealth is dependent upon the relationship between income and spending coupled with the amounts, and cost, of servicing debts. In any period where debts are large, it is unlikely that much wealth will be acquired. Periods during which no surpluses are put aside means that the ability to afford to retire will be delayed.

The picture is not as simple as I present however. The modern consumer is encouraged to spend first and think later. There are many ‘desirable’ purchases available on easy credit. Quite often spending will exceed income with a period of getting back on track following this. This is the challenge to saving enough for retirement.

The position in retirement is the opposite of the above. Ignoring income generated from investments and savings, the only genuine income will come from the state pension and possibly defined benefit pensions. All other income has to be generated from the wealth acquired, either by living off income generated by that wealth or by selling off assets, for example, drawing down on their wealth.

If the holistic approach is taken to wealth creation, then when retirement occurs they will have a range of assets that have different growth prospects and tax treatments. The art of stretching that wealth is to draw down assets with the least growth potential in a tax-efficient manner to make up the income shortfall to meet spending needs. This may be complicated by the desire to leave bequests and inheritance tax planning.

There are though products available that translate one form of wealth into another. An annuity provides an income stream for life but requires the allocation of a large part of the acquired wealth to purchase the product. At present annuities have no value - from next April, with the creation of the secondary annuity market, they will have a value but usually a lot less than the original cost of buying the annuity.

Similarly equity release converts an illiquid asset, a home, into a capital sum which can then be used to close the gap between spending and income in retirement.

By drawing down on wealth to meet spending needs, we still have not met the requirements of large purchases. However an individual could look upon themselves as their own bank. I often cite the example of a 71-year old retiree who requires a loan to replace their roof or windows. Credit cards are too expensive; Bank loans have short repayment periods and therefore require relatively large repayments; the amount required on its own is probably too small to justify a mortgage or equity release solutions. However, if borrowed from their own wealth, up to age 75 they could receive tax relief on repayments made to their pension.

For larger purchases, can the money be released from wealth? Probably it will have to, as a bank may not be willing to lend. Will the purchaser be willing to amend their spending to reflect their reduced wealth? This is the subject of my next article.

In both working life and retirement, wealth creation and management are essential. However income, spending and debt have different dynamics in retirement than they do while working.

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