When Cole Porter wrote the song “Who Wants to be a Millionaire?” in 1956, a million dollars really was a serious amount of money. Nowadays inflation has made that magical seven digits less impressive. But retiring with a big pension pot still exerts a psychological hold on pension savers.
While retiring with a million may be an unrealistic goal for many savers, for others it may not be desirable for tax and income reasons. Here, we look at the many possible answers to the million-dollar question.
Beware Big Targets
Targets are important in personal finance and setting yourself the challenge of getting to the million mark is an admirable goal. But in one of our most recent personal finance pieces, we looked at the importance of setting SMART goals, and while a seven figure pension may be “specific” and “measurable” it isn’t very “adaptable” because it’s a binary target. Even If you get to half a million, this may still might be enough for some people. For example:
- A pot of £500,000 would last 30 years paying out £22,000 a year, assuming your investments grow 4% a year (after charges and inflation) and you don’t take a tax-free lump sum
A big stretch goal may not be “realistic” (the R in SMART), anyway. This is where human psychology comes in: if you set an over-ambitious target for anything, not achieving it can be demotivating, especially during times of financial stress such as redundancy. Retirement savings are one of the hardest financial goals to set because of the long timeframes involved and the many unknowables, such as health, how long you will keep working, and how long you will live past retirement. It’s a marathon not a sprint, and you may stop running altogether if the going gets tough.
(Worried that your pot is too small? We have some tips here.)
Income Over Lump Sums
David Blanchett, head of retirement research at Morningstar, says a “one size fits all” monetary target may not be the most effective way of planning your post-work years. He prefers a more individualised approach based on your current income and what you want to spend in retirement. The question he asks is: “How much do you need based on your circumstances?”
It seems obvious, but if you are a high earner, you will need a bigger pot if you plan to maintain your current lifestyle through retirement. With interest rates and government bond yields currently so low, a seven-figure savings pot won’t fund a lavish lifestyle.
What income should you expect with a pension pot of £1,000,000 at the age of 65?
- Assuming that 25% is taken tax-free as a lump sum, you can expect a gross income of £34,000 a year. Without taking any lump sum, this income would rise to around £45,000
As Blanchett points out, the more you earn, the bigger your pot needs to be – that might mean the magical million is not enough.
Staying Invested vs Cashing In
Even if you are lucky enough to hit retirement with a pension pot of £1 million, it’s not all plain sailing. These days, retirees have a host of choices of what they do with their savings including tax-free lump sum, annuities or drawdown.
Given equities’ record of outperforming cash and bonds, and the current low yields on offer, many retirees now choose to stay invested in the stock market to keep their money growing even after they have stopped working.
If you have £1,000,000 in cash rather than in a pension scheme (lucky you)– how long would that last if you just paid yourself an income from the interest? Based on current savings rates, if you put the cash in an account paying 0.1% in interest, you could earn £1,000 a year.
What if you dipped into the savings pot too?
- In theory, a £1 million pot would last 40 years if you withdrew £25,000 a year. But this is where inflation bites: in reality this would last just 20 years if you increased your withdrawals each year to keep up with the cost of living.
4% Rule
Advisers have historically relied on the “4% rule” as a guide to making sure you don’t outlast your savings: the idea is to withdraw 4% of the value of your portfolio out every year as income (so £4,000 if you have £100,000 saved) and adjust that percentage for inflation every year. It keeps your money invested in the stock market, which should in theory outstrip inflation.
Morningstar analyst Amy Arnott says the rule is still a reasonable starting point, but you may need to take out a smaller percentage given low interest rates, longer life expectancies, and stock market volatility. The 4% rule does lend itself to simple arithmetic:
- a 4% spending plan requires a portfolio of 25 times annual spending (4x25=100). If you know that you want to spend £50,000 per year in retirement, you can multiply that amount by 25 to reach a desired portfolio size of £1.25 million.
Who Wants to Be a Millionaire?
For those with a decent time horizon, retiring with a million may be more realistic than you think. But here’s something else to bear in mind: the real spending power of £1 million in, say, 40 years will be significantly lower than it is today.
UK savers have another problem too: the lifetime allowance. Currently £1.07 million, if you save more than this in your pension pot, you could be landed with a punitive tax bill. Older pensions (final salary or defined benefit pensions) are simpler, as you know how much income you’ll receive each year.
But these days, it’s more common to draw your pension income from a number of sources, including new pension schemes, personal savings and the state pension. That means, it entirely possible to achieve a comfortable retirement income by combining some or all of these without needing the seven-figure pot of gold.
Small Steps
Morningstar personal finance expert Christine Benz says the decision to retire should not always be based on meeting a financial target. As the Covid-19 pandemic has shown, quality of life is as important as hard cash. There are many steps you can take to get out of the “is my pot big enough?” mindset, she says.
“Rather than looking to a single blockbuster solution to help make up for a savings gap, what if you were to consider a little bit of several prudent strategies – being willing to cut your standard of living a bit in retirement, working a bit longer, and investing a bit better, for example?,” she says. “The virtue of taking several small steps – rather than relying on a single Hail Mary action – is that if one of the variables doesn't play out as you thought it would, you may still be able to save your plan.”
