The £1 million question: how much do you need to save for retirement?
Most people want to know when they can afford to retire, asking what size of pension pot will be enough to live on comfortably. The answer to this question is that it depends. Many factors will come into play: the age of an individual, their current earnings, their health, their lifestyle expectations, their interests, and their ongoing financial commitments including secured or unsecured debt.
Enough is enough
The ideal savings pot size will vary for each individual, but the answer to the question of how much a person should save will, for most people, be as much as you can.
This simplistic aim has been complicated by government policies. Since 2006, the government has placed a limit on the money that can be held in a pension fund without attracting punitive tax charges. This limit has been eroded, and now stands at just £1 million. To most people, this sounds like a lot of money, and in a way it is, as most people will not succeed in saving this amount (see our analysis in issue 533 of the contributions required to save the pension minister’s notional £250,000 target).
When you look at the income that can be safely taken from the fund in drawdown (where an income is taken from the fund itself, rather than buying an annuity with the fund), it is not much after all. The consensus in the financial services industry is an income of no more than 4% of the fund can be taken each year with a reasonable prospect of preserving the fund, rather than running it down (see Retirement Income, page opposite, for more on this rule).
This would indicate a gross income of £40,000 per year could be taken from a £1 million pot. This looks good, but is hardly a king’s ransom, and will be further reduced by tax. If 25% of the fund has been taken tax-free, courtesy of personal allowance, safe income reduces to £30,000, again subject to tax.
Ideally more than £1 million should be set aside. The idea of doing this is intimidating to most people, but those who can do it will find they are subject to tax charges of at least 25% on the excess, and 55% if the excess is drawn as a lump sum. This is punitive, and is effectively a tax on the thrifty and prudent, and those who make good investment decisions.
It is particularly unfair when the total amount that can be invested in a pension each year, including contributions from employers, is limited to £40,000, and much less in some cases, as per the annual allowance.
Those already drawing from their fund, even in tiny amounts, will only be able to put in £4,000 under plans announced in the Autumn Statement. Many people are therefore looking for alternative savings vehicles such as ISAs.
Returning to the original question of how much in savings is needed, we need to understand retirement income requirements will typically not be linear. Most people will need more money earlier in their retirements when they are active and well.
There will be the flat-rate basic state pension worth around £8,000, or twice that amount for a couple where the right entitlement has been built up. Subsequently, a conscious decision can be made to erode the capital in a private savings fund.
The real question is one of adequacy of saving. With the average pension pot stuck at £30,000 for many years, a £1 million fund is the stuff of dreams for the vast majority of people. Perhaps something more realistic would not seem so unattainable, so I will provide a two-word answer to my own question: six figures.
Malcolm Small is executive chairman of the Retirement Income Alliance.