Investing £1 million into your pension: why it’s not as crazy as it sounds

Becky O’Connor explains how you could retire with a dream pension pot.

With news today that the chancellor is planning to freeze the lifetime allowance on pensions at £1 million – that’s the amount you can invest into a pension before tax is due – some may be wondering, so what? That’s a ‘pie in the sky, I should be so lucky’ number.

Actually, it’s not so crazy – and sadly, such an amount doesn’t go as far as you might think in retirement.

With a £1 million pot, you could take £250,000 as a tax-free lump sum, then when you reach 68 (if you are a younger worker now, this will probably be your state pension entitlement age) an annual income of £36,000 approx. that would last until you are around 93. (You can use this calculator to play around with your assumptions and work out how close to £1 million you could get.) And if you want to know what other pot sizes will generate in retirement, read this excellent piece by Moira O’Neill.

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While £36,000 is more than the UK average salary, and someone who had worked enough to build this up would also presumably have the full State Pension entitlement, too, it’s not enough for the life of Riley. It’s certainly not as abundant as the income from some of the final salary arrangements that many older retirees are on. If your spouse doesn’t have much in the way of pensions, that amount has to cover living costs for two. And if you still have mortgage costs or rent to pay off, you will still be shelling out around a third of that income on housing.

Disappointed? You could be. As if you are then penalised by a tax charge of either 55% of your lump sum or 25% of your income taken on this pot if it rises to more than £1 million, you might reasonably be left wondering why you bothered ploughing so much into your pension for all those years, particularly given the fairly normal looking income it has provided for you.

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For someone starting life on an average graduate salary of £29,000 and putting in a little more than double the auto-enrolment minimum of 8%, including employer contributions and tax relief, £1 million is within reach.

It’s admittedly much harder if you stick at the minimum auto-enrolment contribution of 8% - if this is what you and your employer pay in in total, you’d be heavily reliant on above average investment growth and bigger salary rises to get to £1 million over the years.

But starting out at age 21 by putting in a higher percentage of salary, say 17% in total (including employer contributions and tax relief), then with investment growth of around 4% and salary rises of about 3% a year (which admittedly, might be punchy to assume every year, but factoring in some higher and lower years of growth), you’d be well on your way to a £1 million pot from the get-go. This would work out as a monthly contribution of £420 approx in the first year of work, rising in line with salary increases, right the way through from 21 to age 68.

It gets harder for those starting their pension later of course; if investment growth isn’t as healthy over all those years, if someone takes time out of work, or if salaries don’t grow so much.

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If they didn’t start contributing until 25 (on a salary of £32,638), they’d need to start with an 18% of total gross salary contribution, which would equal £485 approx contributions per month in that first year, then rising in line with salary.

All this is to say that for someone with a generous employer who double matches contributions, for instance, up to a certain limit (say you put in 7% and your employer puts in 14%), that £1 million pot becomes more doable.

Factors that increase your chances of hitting a £1 million pension pot:

• The more generous an employer pension scheme (double matching, etc)
• The higher your salary rises
• The higher investment growth
• The lower the total charges on your pot
• The earlier you start

NB. The % of your salary you have to contribute to reach that goal rises for every year you delay investing in a pension.

So while the chancellor is unlikely to raise many eyebrows now with a lifetime allowance freeze, should it remain in place for another 20 years, say, there would be more people – people who might not feel that wealthy - left smarting, as their pension values approach and breach this seemingly unreachable number.