Retiring by instalments

These days retirement is a nebulous concept. It’s not always obvious where work ends and retirement begins. Yet there is usually a signal. It may start with a reduction in working hours or a move to a less stressful role. It could be a switch from employment to self-employment (or even starting a new company). Nevertheless, there is generally some fracture in the pattern of work that denotes a new phase that will eventually lead to outright retirement.

This transitional approach may be motivated by a need to boost savings, but can be symptomatic of other issues. It could be to maintain the social benefits that work brings and stave off loneliness. It may be a desire to stay active mentally and/or physically. Perhaps it’s to continue to enjoy the status and self-esteem work often confers. 

The advantages of delaying outright retirement

Whatever the physiological benefits of this approach, there are financial benefits too:

• More time to save 
• More time for savings to grow (though, of course, investments can fall as well as rise)
• Option to defer the State Pension if working beyond State Pension age
• Better annuity rates or higher withdrawal rates from drawdown

Mind the gap

Often the transition from full time employment is commensurate with a reduction in earnings, which may trigger a need to supplement income. Remember NI contributions are no longer payable over State Pension age and some costs, commuting perhaps, could reduce, so the gap may be less than the difference in earnings. Nevertheless, if a gap does exist, there are ways to deal with this: 

• State Pension. Someone who has reached State Pension age could take their State Pension. However, it’s not possible to take part of the State Pension, which means the extra income could push someone into a higher tax bracket. At best, it may provide more income than the client needs (though any excess could be used to fund further pension contributions under the right circumstances). 
• Top up from private pensions. It could make sense to top up any shortfall from private pensions. If so, the following should be borne in mind: 
  • Leaving aside the tax-free cash element, income from private pensions is taxable so this approach could push someone into a higher tax bracket. 
  • Taking income could trigger the MPAA. This may be less relevant now the MPAA has been increased to £10,000. 
  • Using the tax-free cash sum to top up income would not trigger any reduction in the MPAA or lead to an increase in tax payable. Also, less income would need to be withdrawn because of the tax-free status. 
  • Income from a lifetime annuity or any defined benefit income would not trigger the MPAA, but would be taxable and can’t be varied (though may increase each year). If the retirement journey begins at a relatively young age, annuity rates might not be that attractive and defined benefit pensions often apply an actuarial reduction if income is taken early. 
• Other savings and investments. An alternative source of income to top up any shortfall could be other savings and investments, particularly those which are tax advantaged like ISAs or the tax deferred status of investment bonds. Utilising the CGT allowance, dividend allowance and personal saving allowance may also create additional income tax-free. More radical solutions could include downsizing or equity release though these are unlikely to be the first port of call for most people. 

Whenever a tax-free solution is used, the amount required will be less than if it’s drawn from a taxable source. Making up any shortfall from sources other than pensions also preserves the favourable tax status on death of funds held in pensions before age 75. 

How can people transition to retirement? Let me count the ways

While some may reduce their working hours or take on a less demanding role to ease themselves gradually towards retirement, these aren’t the only options. In some cases, people see this transitional period as an opportunity to continue working, but to become their own boss. There are almost one million self-employed people between 55-64 and more than 400,000 people over 65 who are self-employed¹. 

The key risk is a shortfall in income but, unlike employees who reduce their working hours or take less well-paid roles, income is likely to be variable, so supplementing any shortfall with a fixed or increasing income like an annuity, defined benefit pension or the State Pension may not be suitable. 

Other people may choose to do their own thing by starting a Limited company rather than becoming self-employed. This introduces additional considerations. In particular, the interplay between income and dividends. The right mix of income will depend on individual circumstances. but does add a further layer of complexity. 

You can discover more about this topical trend in our report 'Reinventing retirement'.

¹ Number of self-employed workers in the UK 2019-2022 by age group, Statista, 2024.