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Why even £1m might not be enough for retirement

Pension savers with even £1m in the bank are likely to be disappointed when they look to secure an income, says David Prosser.

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You only have a million? Oh dear

Would you feel well-off if you had £1m in the bank? Probably but pension savers who manage to put away that much by the time they retire are likely to be disappointed when they find out what £1m is worth when it comes to securing an income. At current annuity rates, a £1m pension fund would buy a starting income of just £20,860, according to insurance company Royal London.

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This figure assumes that you want the pension to increase in line with inflation each year and to pay a survivor's pension of 50% of the income to a spouse after your death. An annual income of about £20,000 with those benefits isn't to be sniffed at, but it's certainly not going to pay for a life of luxury during retirement.

The £1m figure is significant because this is the maximum amount savers can now build up in a private pension, including investment growth, without having to pay punitive tax charges. This "lifetime allowance" was cut to £1m from £1.25m in April this year as recently as five years ago, this cap was £1.8m.

The reduction in the lifetime allowance, along with a collapse in annuity rates during the years in which the UK's interest rates have been maintained at rock-bottom levels, has dramatically reduced the retirement income it is possible to generate using private-pension plans, even for those able to save large sums. Even those who forgo any inflation-proofing or spouse's pension would today be able to achieve a maximum pension income of only £45,400 on retirement, given today's lifetime allowance, says Royal London.

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By contrast, in the 2007-2008 year, when annuity rates were around 60% higher, someone saving the lifetime allowance of £1.8m could have expected an annual pension income of £117,760. Taking into account the effects of inflation, the maximum pension available has thus fallen by more than two-thirds.

Retirees who want a respectable income while also having protection against inflation, or who want to be able to leave some of their pension to their dependants on their death, may therefore need to think more creatively. We look at some alternatives in the column on the right.

How to get a better dealfrom your pension fund

Even those savers who want to convert all of their pension savings into guaranteed income using an annuity have a number of options. Above all, buying more limited inflation-proofing an annual pension increase in line with the lower of inflation or 3%, say will add value. With a £1m pension fund offering a 50% spouse's pension, this would boost the starting income from £20,860 to £27,100.

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Another option is an income-drawdown scheme, where your pension fund remains invested and you draw income directly from it, to convert some or all of your savings into income. You could, for example, use a proportion to buy a non-inflation-linked annuity, guaranteeing a certain amount of income each year, leaving the rest of the savings invested in assets with the potential to deliver inflation-beating returns.

Income-drawdown schemes have the added advantage of enabling people to leave unused pension savings to their heirs in a tax-efficient way. Savings passed on to your heirs if you die before the age of 75 are usually tax-free; otherwise, your heirs will normally only have to pay income tax on the money at their marginal rate. The availability of these options means that savers with large sums in their pension funds should consider taking independent financial advice on their options in the run-up to retirement, to ensure they meet their income objectives in a tax-efficient way.

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