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Pot stuff

I understand that if I want to retire on an income of £20,000 a year, I will need to build up a pension fund of £400,000. Is that correct?It actually depends on a lot of factors and, while it may well be the case that you would need £400,000, very possibly you might need a lot more.

There are a whole host of questions that need to be asked before I can answer you so let us start with the age at which you want to retire.

The younger the age at which you intend to retire, the bigger the pension fund you will need. The logic is that the younger you retire, the greater the period of time that you will spend in retirement and, therefore, the bigger the pot of money you will need to secure the income to be paid to you. If you use an annuity as the financial instrument to convert your pension fund into income, then receiving £20,000 a year implies an annuity rate of 5 per cent. A man aged 55 today might be able to benefit from an annuity closer to 6 per cent so it seems reasonable to assume that £400,000 might buy £20,000 of income.

But – and there is always a but, isn’t there? – if you intend to retire at a much younger age, your £400,000 pension pot might not buy you as much as £20,000 simply because annuity rates tend to be much lower for younger people.

On the upside, so to speak, if serious ill health forced you to retire, then you might benefit from an enhanced annuity rate by virtue of your impaired life status. Higher annuity rates are generally available for those individuals whose life expectancy is considered to be reduced by illness.

Is the £20,000 you expect to receive a gross or net amount? The above estimates assume a gross income of £20,000 a year. Tax will be payable on this income and, therefore, your spendable income will be much lower. If you require £20,000 net, then you will need a much bigger pension fund, depending on your income tax position in retirement.

When you retire, will you need to make provision for a surviving spouse? If your pension is to be paid to you for as long as you live and then on your death to be paid to a surviving spouse, then the starting point is likely to be lower. There will be a price to pay in the form of a reduced starting level of income. This will be particularly true where the survivor is female as women tend to live longer than men.

Most married couples tend to choose for the continuation of income at half the rate payable to the first spouse.

What about inflation? So far we have assumed that your pension income of £20,000 gross will remain at that level for as long as it is paid. This ignores the impact that inflation will have on the purchasing power of your pension income. You may wish to take an income that increases each year in course of payment. The greater the rate of pension increase, the lower the starting point of the pension purchased by your fund.

To put it another way, you will have to build up a bigger pension fund to provide the desired level of income.

What other savings and investment assets will you have? So far we have been talking about pension funds and pension income. These are convenient terms for us to use but they do not embrace all of a person’s wealth at retirement. You may have other savings and investments and even assets like the equity you have built up in your home.

Is the £400,000 all made up of a conventional pension fund or might it not more reasonably be made up of savings, shares, collective investments, maturing life insurance policies and so on?It may well be that the totality of your wealth is what is used to determine the level of your retirement income. Some forms of savings – Isas, for example – may not benefit from tax relief on contributions on the way in but they do allow for the payment of tax-free income on the way out under current rules.

On the subject of tax, we must not forget the much loved tax-free cash lump sum. If you require a lump sum and the £20,000 of annual income, then you will need to increase the pension fund size by a further 25 per cent.

You may get some real value by sitting down with an IFA to work out exactly what you need but £400,000 might just be a reasonable start.

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