Beware: you may be saving too much in your pension

I listened to Blackrock’s Larry Fink speak at the National Association of Pension Funds conference in Edinburgh this week. He was very clear that everyone must save more; that his industry must somehow “communicate the urgency to save today”; and that anyone who didn’t act on this urgency  would face a “miserable future”.

You might think this is something of a statement of the obvious.  But it isn’t. There is actually a large group of people who, far from under-saving into their pensions, are dangerously over-saving.

Pensions legislation incorporates something called the ‘Lifetime Allowance (LTA)’. It was introduced eight years ago and has fluctuated all over the place since then.  It started at £1.4m, went to £1.8m and then fell back to £1.5m. And it’s about to change again.

From 6 April it will be £1.25m. You can apply to have your limit frozen at £1.5m, but assuming you don’t, if on the day of your retirement you have more than £1.25m in your pension pot, you will be taxed on the excess at a rate that could hit 55% plus (55% on anything you take as a lump sum and 25% plus your normal income-tax rate on whatever income is generated by the excess).

You might think this is of no relevance to you whatsoever – you haven’t put £1.25m in your pension account, and you don’t ever expect to. But you are missing two points.

The first is that, while the LTA sounds like a contribution limit, it isn’t. It doesn’t refer to how much money you can put into your pension. It refers to how much you may have in your pension when you finally retire.

The second is the magic of compounding. £1.25m sounds like a lot. But add in investment returns, inflation and time and it’s nothing.

Let’s look at it in terms of investment returns only. Over the last 50 years or so, the stock market has given us an average real return of about 5.5% a year. Go back further and it comes out at more like 7%. Let’s take 6% for the sake of argument (I’m using US numbers here just because the data goes back further).

Then let’s use as an example a 38 year-old man with £250, 000 in his pension.  He probably hasn’t even noticed the change in the lifetime limit, given that his current savings come in at a million less than it does.

But guess how much he will have in his account in 27 years (when he is 65) even if he stops saving right now? £1.2m. He’s effectively almost at the limit already. What if he invests really well and makes 7% a year? £1.55m. And what if he keeps contributing to his account to the tune of £500 a month until he retires? £2m.

I’ve ignored costs in this, but you get the picture. He’s in danger of having to pay some pretty nasty taxes on what he probably thinks of as far too small a pot to interest the government.  And the better he invests, the more risk he is running.

There’s more. In the example so far I have only used inflation-adjusted numbers. But doing so makes the implicit assumption that the lifetime limit is raised along with inflation. That’s a hopelessly optimistic assumption.

Pensions savings are easy targets for broke governments. A very easy way to both save on tax relief upfront and to claw it back later is simply to use ‘fiscal drag’ to cut the amount people can save on an annual basis and have on vesting over time. Even assuming the limit stays where it is in nominal terms is pretty ‘glass half-full’: the Liberal Democrats are already lobbying to cut it to £1m.

Still, let’s assume that the £1.25m limit stays exactly where it is. Let’s then assume that inflation runs at 3% a year until our would-be pensioner retires. He now has a sum of just over £2.5m on retirement. Double the permitted amount. His tax bill on his “tax-free” pension is going to be £687,500. Or maybe more: BlackRock puts the annual total return (not inflation adjusted) on UK equities over the last 42 years at 11.3%. If our man makes that, he’ll have £4.5m to his name. So he could end up effectively paying a total of 55% on £3.25m of it.

And that assumes that he doesn’t save any more into his fund until he retires. If he makes the mistake of tucking a little more away every month (as we tell everyone to do) the bill will be even higher. As it stands, the LTA is a classic tax on mathematical ignorance and inflation.

You will say that none of this is a given. You’re right. It isn’t. Investment returns over the next 27 years may be lower than usual, making the risk of hitting the limit slightly lower than I suggest – although valuations don’t really suggest that is the case.

The LTA may well also rise over time. But even if rises with inflation, our man is still in trouble.  And I can’t see it rising with inflation. There’s a major political move afoot to reduce the tax relief that goes to pensions. Doing it via cuts in the real LTA has the twin benefit (from a politician’s point of view) of being simple to implement and hard to understand.

So what do you do about all this? The first thing might be to accept that this is the way of it. We live in a deeply indebted state that must finance itself. The more you have, the more you are going to end up paying one way or another – so you might as well just keep saving and hoping for the best.

The next is to look into applying for either ‘Fixed Protection 2014’ or ‘Individual Protection 2014’ both of which – if you apply fast – can fix your LTA above £1.25m (we looked at these last week, see here for more detail).

But if you aren’t already over funded – and I think a lot of you will find that you are – the best thing to do is to hedge your bets. My own guess is that the LTA will fall to around £400-500,000 in real terms – the amount that yields enough of an income to stop you being a burden on the state in your old age. So, use your ISAs first and then save no more than enough for the miracle of compounding to get you to that level by retirement. Then put your spare cash somewhere else.

• This article was first published in the Financial Times

  • Knowlesi

    A 38 year old with a 250k pension pot ? Can’t imagine there are too many of those knocking about ? Or perhaps im just well behind the curve with my pension…

  • Merryn

    Several people have asked about how it works for defined benefit schemes. The LTA still applies but the value of the pension is calculated differently. More here

  • Marko

    But ISAs only allow around 12,000 a year. For higher earners that still leaves a lot of cash that needs a home.

    I am suspicous the government is doing this to prop up house prices. All the excess pension cash minus ISA allowance will go into property as there is no suitable alternative.

    VCTs are a possibility but don’t appeal to many.

    • CKP

      Agree with the view on VCTs, I invested in several these when they offered up to 40% tax relief and the returns have been universally disappointing. The high charges (typical TER >3%) are to blame. Most have failed to return the initial capital before tax relief. Avoid

  • joolzsmith

    I read your other article on this as advising that ‘fixed protection’ was available, if you are quick, to protect any amount up to £1.5m. E.g. in case it will exceed LTA in the future, as described in your scenarios. Checking with HMRC it seems much more complicated, as several forms of protection are possible. But also simpler, and much less useful (less protective), in that your pot must already exceed £1.25m. Now or on 5/4/2014 depending upon which type of protection you seek.
    So those of us who are on track to exceed LTA (ignoring any further reductions), but not there yet, are already trapped? That is my reading leastways

  • steve

    Hi Merryn, Can I ask questions?

    Is a divorce the only solution? Because no pension provider has an answer this future timebomb of a problem!

    I am 44 year old happily married man, whose wife has no pension and is not likely to be working due to our children being at School. Who did not buy a big house but did save into 3 personal pensions. Is there a way to transfer 2 pensions over to my wife, so we can both retire on sensible pensions, instead of sharing one taxed pension in our old age?

    thanks for all your help over the years.

  • joolzsmith

    hmm… on closer inspection Fixed Protection 2014 works with less than £1.25m as a current pot value. But Individual Protection 2014 only works if you have already reached £1.25m. So this is still usable, which is some good news in the midst of a sea of woe! As Merryn said it does mean that you cannot add any more to the pot from now on, but at least the pot can grow to £1.5m before you get clobbered.
    This all still strikes me as extremely unfair! Governments desparately want people to provide for themselves, but then penalize them for doing so. Further, they destroy annuities with fake interest rates, but then trash drawdowns too: not only do you get taxed twice on dividend income, but if the fund continues to grow (so you do not have to fall back on the state) then you may break LTA. As you say this is extremely possible, especially if the fund grows a lot faster than 120% of the artificially low GAD rate, which is all you can extract each year

  • Merryn

    Here’s another interesting take on this one.. this reader thinks that continuing to contribute past the LTA might be worth it – in some circumstances.

  • Merryn

    @steve I’m afraid I can’t answer that – I really don’t know. I suspect you can’t transfer pensions in that way (it would be far too easy!) but it is probably worth calling HMRC to check just in case. Do let us know..

  • CKP

    I agree with MSW that the lifetime allowance is unlikely to rise with inflation. UK tax treatment of pensions has been very generous until recent years. Some other countries e.g. Canada allow transfer of pension assets to spouses but in the UK this requires a court order, usually as a result of divorce. For the self employed, it may be worth trading as a Ltd company and paying large pension contributions to the spouse as an employee to make use of his/her LTA.
    Whilst annoying for middle class pension savers the LTA at current levels won’t push anyone into poverty and there are muchos bills that need to be paid. The govt essentially keeps 55% of anything over the LTA but bear in mind that this cash has benefitted often from 50% up front tax relief and compounded for decades taxfree. Not such a raw deal if put into perspective. But i will be reducing my SIPP contributions in favour of ISAs.

  • Merryn

    @CKP – good points – see the other blog I refer to above for more on why paying the 55% might make sense

  • Merryn

    The detail should anyone want it on fixed protection etc is here

  • CKP

    The equation is further complicated by those earning between £100-110k who can escape the 60% marginal tax rate by paying into a pension, thereby dropping their taxable pay. Further down the pay scale £50-60k, there are also those that can retain their child benefit by paying into a pension. Also consider that on salary sacrifice scheme contributions you benefit from not paying employees national insurance and the employers will often add the employer’s NI savings into the pension. Whilst the 55% sounds excessive, there is no further income tax to pay, income tax would however be payable on income drawn from the pension fund below the LTA.

    Nothing is what it seems when it comes to UK tax and pensions.

  • Merryn

    Anyone in any doubt about how fiscal drag works on tax allowances might look to the front page of the Times today – by next year there will be 1m more taxpayers in the 40% bracket than in 2010. So much for helping hard working families.

  • Merryn