A £1 million pound pot might sound like a lot of money, but it may not stretch very far when it comes to providing a long-term retirement income.
While achieving the designation of ‘millionaire’ once meant you had it made in the shade, today’s landscape of higher inflation and longer life expectancies means that enviable £1 million pound pension pot might not buy you the kind of retirement you always imagined.
To put it in perspective, a 68-year-old investor in good health who uses their £1 million pension pot to buy an annuity can expect to earn about £36,000 a year[1]. That’s inclusive of withdrawing a tax-free lump sum of £200,000 (or 20%) of your pension pot’s total. But additional features – such as protection against inflation or a pension for a surviving spouse – could cut that total substantially.
The £1 million figure is key when it comes to UK pensions because the current ‘lifetime allowance’ – the amount you can withdraw from your pension without triggering additional tax charges of a whopping 55% – stands at just over that: £1,073,100 for fiscal year 2021-22[2]. It applies to all the pensions you have, with the exception of your state pension.
The lifetime allowance is designed to increase each year in line with the Consumer Price Index[3] (or CPI, otherwise known as inflation). Even so, many investors may be relieved to learn that there are several things they can do to improve their retirement income without exceeding this critical figure.
Consolidate your pensions
A good starting point is to merge your pensions into one large pot. Carl Drummond, Senior Wealth Planner, says: “This can help to make your pensions easier – and sometimes cheaper – to manage, with just one set of paperwork to handle. But it is vital to check that, by transferring your pension, you will not lose a valuable guarantee or incur expensive penalties. Particular care should be taken with defined benefit, or final salary, pensions, as you may lose more than you gain by transferring.”
There is a growing preference among investors to put their pensions into ‘drawdown’, enabling them to take money as and when they like. This has the added benefit of leaving the pension fund invested, with the potential to continue growing.
However, don’t eschew investment schemes other than pensions, especially if you are creeping toward that lifetime allowance. However good the tax relief on your pension is, there is no point in investing further money if you are going to pay up to 55% tax on the benefits. Diversifying your investments can allow you to keep a bigger chunk of that well-earned £1 million pension pot.
Money taken from a pension in drawdown can be combined with cash from other types of investment, enabling the investor to choose the most tax-efficient way to generate an income. This might include investments such as ISAs and investment bonds, or using their annual Capital Gains Tax allowance to take cash tax-free from investments that otherwise offer no tax protection.
Money taken from a pension in drawdown can be combined with cash from other types of investment, enabling the investor to choose the most tax-efficient way to generate an income. This might include investments such as ISAs and investment bonds, or using their annual Capital Gains Tax allowance to take cash tax-free from investments that otherwise offer no tax protection.
Keep on working
Many people are also choosing to continue working past their normal retirement age on a part-time basis. This is unsurprising, as the average UK pension pot at age 65 is £61,897 – well below that million-pound mark. “Working part-time helps to supplement a retirement income or, if the person has sufficient income, to continue saving. It also provides social interaction and structure to a recent retiree’s life – something that many people who have had busy and fulfilling careers find hard to give up,” says Drummond.
Provided you have sufficient money to live on now, you could also increase your eventual retirement income by deferring your state pension. The amount you receive, based on your National Insurance contributions, increases by 1% for every nine weeks you delay, or just under 5.8% for every full year. Based on the full new state pension, which provides £179.60 a week, or £9,300 a year, you would get an extra £10.41 a week by deferring for just one year. This amount will then usually increase each year, in line with the CPI.
Buy an annuity
Few investors opt to buy an annuity (an insurance contract that pays a guaranteed income for life) with their pension funds these days. This is because “once you have bought one, there is no going back,” Drummond says. “If you die a few months, or even a few weeks, after buying an annuity, the insurance company will usually get to keep the money.”
That being said, many investors consider this is a good option, whether or not they’ve achieved that £1 million pension pot goal. Annuities address the risk of a pensioner outliving his or her savings by paying out a guaranteed yearly salary. They can also be an effective way of de-risking your investments.
For those investors seeking the security an annuity offers, it is essential to make sure they get the best deal possible. Research by the Financial Conduct Authority[4] found that eight out of 10 people benefit by shopping around and buying an annuity from a provider different from the one with whom they entrusted their pension.
There is one exception: if your pension includes a guaranteed annuity rate, or GAR, that was fixed when you first started investing, it may provide a bigger annuity income than you could get by switching to another provider.
Investors with serious medical conditions, or lifestyle habits that could limit their lifespan, may be eligible for an impaired or enhanced annuity. This type of contract pays a higher rate of income to purchasers who smoke, or who have a condition such as diabetes, high blood pressure, cancer or kidney failure. “Buying an impaired life annuity can make a difference to the amount of income you receive,” says Drummond. “One of my clients receives more than double the income he could expect if he were in good health.”
[1] https://www.fidelity.co.uk/retirement/calculators/retirement-income-estimator-pi/
[2] https://www.gov.uk/government/publications/setting-the-standard-lifetime-allowance-from-2021-to-2022-to-2025-to-2026/setting-the-standard-lifetime-allowance-from-2021-to-2022-to-2025-to-2026
[3] https://www.ons.gov.uk/economy/inflationandpriceindices
[4] https://www.fca.org.uk/news/press-releases/fca-finds-annuity-market-not-working-consumers-competition-market-study-launched