Does a pension pot of £1 million make you rich?
Better off than most for sure, but rich? That’s probably a debate for another day. What is certain though, is that building up a large pension triggers several problems. Many of which you might not be aware of.
Here are three which spring immediately to mind, and the solutions.
Problem 1: A tax on your pension fund
One of the key reasons pensions are attractive is their tax-efficiency. Contributions qualify for tax-relief and the growth is tax-free.
So far so good.
But for those people with larger pension funds, the Lifetime Allowance lurks in the background. Anyone who breaches the allowance, without having applied for protection (more of that in a moment), will have to pay large tax charges.
For people with defined contribution (DC) schemes; Stakeholder Pensions, Personal Pensions and Self-Invested Pensions (SIPPs) the Lifetime Allowance is currently set at £1 million. For those people with defined benefit schemes, also known as final salary pensions, the allowance is usually 20 times their pension in the first year plus the tax-free lump sum.
It’s not just people who have already built up a £1 million pension who will be caught either. If you are young and paying relatively large amounts into your pension, you may well fall foul of the Lifetime Allowance in years to come. The value of your pension pot will rise over time and move closer to, and possibly breaching the Lifetime Allowance. Remember too, when it was introduced it was set at £1.8 million and has been regularly reduced since.
The solution: There are three key steps you should take.
Firstly, confirm whether or not you have a problem. That isn’t always easy, especially if you are relatively young and still accumulating money in your pension.
Secondly, consider the various protections which are available for people with large pensions and help avoid the tax charges.
Thirdly, plan carefully. Pensions are a hugely tax-efficient way of saving for retirement, but get it wrong, breach the Lifetime Allowance, and you could be stung for a tax bill which was probably avoidable.
It’s worth finding a solution too, the tax rate is eye wateringly high; 55% if you take the excess, above the Lifetime Allowance, as a lump sum, 25%, on top of your normal income tax bill if you take it as an income.
Problem 2: Can you afford to retire?
There’s no denying that a pension pot of £1 million is substantially larger than most and certainly a significant amount of money.
But, is it enough to retire on?
Let’s test your pension knowledge. How much income could a 65-year-old get from their pension, if they bought an inflation linked Annuity, with 50% of the income continuing to their spouse when they die?
£50,000 per year? No
£40,000 per year? No
£30,000 per year? Getting closer.
The answer is £26,478 per year, and that’s before tax. (Source: The Money Advice Service)
Granted, it’s unlikely someone with a pension of £1 million would buy an Annuity, but the example shows that a relatively large pension pot only provides an income around the national average wage.
Could you afford to live on it when you retire?
The solution: Planning and making provision.
If you want to stop work one day you need to build up an independent source of income, paid to you even if you don’t go to work. That might be a combination of investments, an inheritance, property, the sale of a business, but it almost certainly involves a pension.
It should definitely involve careful planning too. We help our clients plan carefully for their retirement with the aid of a financial forecasting tool. This projects their finances, years, even decades, ahead, to show their financial future based on certain key assumptions. Only when you use a financial forecasting tool can your accurately predict the future.
Problem 3: How do you take your income?
Pension Freedom, introduced two years ago, gives people many more options in retirement. Gone are the days of having to buy an Annuity.
But, how do you ensure the income is guaranteed to last for the rest of your life? And that of your spouse? Whilst ensuring that there is some money for you to pass on to younger generations, or even charity?
The solution: Very careful planning.
The income you need on the day you retire will change as you grow older. Your income requirements may fall, for example later in retirement when you become less mobile. Conversely, you may need more, to combat the effects of inflation or pay for care as you get older.
You may also need lump sums of capital.
Your existing assets need to provide this money for the rest of your life, and that of your spouse. You may also want to leave something behind to your children.
That again means detailed financial forecasting to ensure that all eventualities are covered. A comprehensive forecast may hold some surprises too. We often find people are too cautious, worried to spend money for fear of running out. In our experience financial forecasting can show the reverse is true, that they can actually spend more money than they thought possible, improve their lifestyle, not run out of money and still leave something meaningful behind.
The moral of this article?
There’s no getting away from the fact, £1 million is still a lot of money.
If you have saved hard and built up a large pension pot though, it brings with it several issues which you need to be addressed. Not doing so could prove very costly.
As financial planners, we are skilled at solving each of these problems, and more. If you have a large pension pot, or want to plan seriously for your retirement, we are here to help.
Call Ben or Jane on 0113 262 1242.
This article is the first in a series to highlight key issues our clients face and how financial forecasting can offer part of the solution.
We know the benefits it brings to our clients and how, as part of a comprehensive financial plan, it can help you achieve your goals and objectives.
To learn more about financial forecasting call us on 0113 262 1242.