Cash Flow Planning: How to Draw From Your Portfolio

Introduction: Understanding Cash Flow Planning

One of the most important parts of financial planning is good cash flow planning. Do I have enough income to cover the expenses I am going to incur over the coming weeks and months?

Budgeting is a topic we've covered in some depth, but it still leaves the question: where is this money coming from? The answer to that is one that we can't give you. In most cases it will come from income from your day-to-day job, but you may also have to draw down on your portfolio in order to cover this. When might this happen?

In-between jobs

When you aren't currently employed, you obviously won't have a monthly income coming in from your employer. You will have to either live on savings, investment income or draw down from your portfolio, and will want to consider how best to do this.

When it is tax efficient

In some cases, it will be more tax-efficient to draw down income from your investment portfolio than to take income from a job. Why is this? Well, once you've used up your personal allowance, capital gains and dividend income are taxed at a lower rate than income. So it will quickly become more tax efficient to spend investment income.

Of course, in the early stages of your career while you are in the wealth accumulation phase, you will want to focus on increasing income rather than taking tax-efficient withdrawals, so this may not be of interest. However, it raises another important case.

Retirement

It is likely that your government pension won't be enough to cover all of your expenses in retirement, at least if you are hoping to have a comfortable retirement and not make any compromises in your standard of living. You will therefore want to supplement the state pension with additional income, and since you will no longer be working, this will have to come from investments or savings.

This might be in a tax-advantaged investment account or even better, a personal pension.

You might hope that by the time this comes around, you will have accrued enough savings to last you until death, and there are various ways you can do this. Standard financial planning advice is to recommend the 4% rule, where you can safely withdraw 4% of your portfolio per year without running down the principal.

So you could take £40k/year gross from a £1m pot in perpetuity. This is what's known as the Safe Withdrawal Rate (SFR)

Taking the Income: Different Withdrawal Methods Explained

So now you know which circumstances to take it, you need to think about how exactly you'll take it out. Which sounds straightforward right? Not exactly - you have a few options here.

Pension Lump Sum

You are able to take the first 25% of your pension pot as a tax free lump sum on retirement, meaning that the first part of your retirement will be subsidised without paying tax. You should look to take advantage of this by staggering the first chunk of your expenses in this first period.

Pension Income

The remainder of your pension (or indeed the whole pot if it is a final salary / defined benefit scheme) is paid out to you as income, on which you will pay income tax at your appropriate rate.

This will likely be lower than your tax band from your working life, but still worth bearing in mind that some tax planning may be necessary.

This is particularly relevant to those who are in the 100k tax trap.

Realising Capital Gains

You are able to sell off assets accrued during your life, and will have to pay the tax on the gain as applicable. Capital gains tax is payable at 10% or 18% if you're a basic rate taxpayer (depending on the asset), and at 20% or 24% if you're a higher or additional rate taxpayer.

This is naturally lower than income tax rates, although potentially subject to change in October's budget. This is a point of interest, and means that you can use capital gains and pension income in conjunction to cover your living expenses.

You should also take care to sell down assets in proportion to your target diversification - selling down too much of one asset could adversely affect your asset allocation.

Dividends & Income

Finally, you can also use dividends from stocks, or income from investments (eg rental property). The dividend tax rate is taxed lower than income, but all investment income will be taxed at your marginal income tax rate - so be aware this will be treated the same as your actual or pension income.

Factors Influencing Your Withdrawal Rate

The main factor that should influence your withdrawal rate is how much you actually need! You should be aiming to balance how much you need, and how much you are able to withdraw sustainably to make your pot last the course of your lifetime.

This is an art and certainly not a science, so there isn't a right way. But by assuming conservative growth rates and predicting the tax you'll pay at each stage, you will be well prepared to deal with the expenses you'll face in the years coming.

Regular Review and Reassessment of Your Strategy

Of course, the other important part of this process is a constant review as things change. You should aim to do this at least quarterly, and work out whether your forecasts, withdrawal rates and tax expectations are still in line.

This is particularly important for things like taxes which are subject to change, and often do change with new governments, politicians and macroeconomic environments. Note that they usually go up rather than down!

Adjusting Your Plan for Market Volatility

You should have accounted for this already, but it's important to make sure that you stress test your plan and account for being able to weather sustained periods of economic downturn. Look at some of the worst periods in economic history, and overlay them onto your plan.

Does it still hold up if the stock market experiences little, no, or negative growth for 3,5 or 10 years? If not, how much. do you need to change it?

The last thing you want to do is be at the whim of the economy and 'bet your retirement'.

Tools and Resources for Effective Cash Flow Planning

There are a number of different tools that people use for personal cash flow planning. Some, also often used by advisers, include things like Voyant and Timeline. Others, built specifically for consumers include Projection Lab, and indeed Strabo's own cash flow planning tool.

You can drag sliders along the cash flow forecasting tool to display exactly how much cash might be available to you at different ages, based on various growth forecasts for your assets.

Conclusion: Building a Resilient Financial Future

As by now you've realised, effective cash flow planning is one of the most important parts of financial planning. The most important thing about this process is making sure that you have enough to sustain your lifestyle after all taxes have been paid. Which is a very important distinction to make.

You need to use your two levers wisely - which assets, if any, to take cash from. Then also how to combine these for an effective tax strategy.

As always, when in any doubt you should contact a financial adviser, which you can also do through the Strabo dashboard. This is particularly relevant if you're an expat or not a UK resident - more details here.