Avoid a retirement cliff-edge


Ed Monk - Fidelity Personal Investing

16 May 2018

How big does your pension need to be for you to be able to retire without suffering a fall in your living standards?

Answering this question is vital for anyone to effectively plan the  funding of their retirement. Most of us don’t envisage being much poorer in retirement, but most also underestimate what it takes to avoid it happening.

Numbers from the insurer Royal London being reported this week highlight the challenge. Taking someone earning an annual salary of £27,000 before retirement, close to the national average wage, the figures show that maintaining their standard of living into retirement would require a pension pot of £260,000.

The thing is, this pension fund wouldn’t actually replicate their income. In fact, if used to buy an annuity - a product that turns pension savings into a guaranteed income for life - at age 65, it would only provide an inflation-linked annual income of just over £9,000. If this was then supplemented by the current full state pension of just above £8,500, their total annual income in retirement would be in the region of £17,800 - or around two-thirds of their £27,000 pre-retirement earnings.

This is the level of earning that Government analysis suggests is required to maintain the person’s standard of living in retirement. It’s lower because costs typically fall once work stops.

Mortgage terms are often set to end at around retirement age, when earned income stops, so it’s normal to enter retirement free of mortgage repayments. Other work-related costs - of travelling to work, say - also fall away while pension income is taxed less heavily than worker income (for now).

What happens, you might well be asking, if costs don’t fall that much? The numbers also include an estimate for the pension pot required for a person who does not see their housing costs fall - either because they still have a mortgage to clear or because they rent their home. In those circumstances, the pot required jumps to £445,000. Saving £445,000 inside a pension when your income is £27,000 is no mean feat.

For those earning high salaries during their career, generating a retirement income worth two-thirds of their salary may not even be possible within the constraints of current pension rules, which limit tax-relieved pension pots to £1.03m.

Using the same assumptions about annuity income, a pension pot worth £1.03m would generate an income of around £36,700. Adding the state pension takes total retirement income to little more than £45,000.

Based on the rule of thumb that you need two-thirds of your pre-retirement salary to maintain your standard of living, it means that anyone earning a salary of more than £67,800 would not be able to achieve this from pension income alone.

If this all sounds scary, rest assured that there’s plenty you can do to avoid a drastic fall in living standards once you retire. It’s no surprise that they involve saving more for yourself, investing at a level of risk to give an opportunity for good capital growth and, perhaps most importantly, giving your savings the longest possible time to benefit from compounded returns.

If you have a work pension where your contributions are matched, take full advantage of this benefit as soon as you can.

After that, look to save more – you’ll still get the benefit of  tax relief on contributions even if there’s no employer payment on top. This could be in your work scheme or through a  Self-Invested Personal Pension (SIPP).

A good way to increase your contributions in a relatively painless way is to “auto-escalate” your contributions. It means increasing the proportion of salary you pay into a pension whenever you get pay rises or promotions.

It even works with modest annual pay rises. If you get a 3% increase in pay, keep 2% but add the other 1% to your pension contributions. It could add thousands to the pot you eventually retire with but, because you’ll still feel some extra money landing in your bank account each month, you’ll barely notice the difference.

If you think you’ll hit the  Lifetime Allowance for pension saving, there’s always the tax-free status of  ISAs to take advantage of.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser. Tax treatment depends on individual circumstances and all tax rules may change in the future. The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.pensionwise.gov.uk or over the telephone on 0800 138 3944.  Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.