Shock: £1m pension pot buys pension of just £21,000

Liberal Democrats annual conference 2014

The government has capped the maximum anyone can save tax efficiently in a pension at £1 million. It sounds like an awful lot of money - and therefore nothing that we need to worry about. However, a new report has revealed that a £1 million pot could leave savers with an income of just £21,000 in retirement. Public sector workers with final salary pensions, meanwhile, will be sitting pretty on up to £50,000 a year.

The report, by Royal London calculated what someone would be left with if they built up the government maximum of £1 million in a defined contribution scheme. If they used that pot to buy an annuity offering a guaranteed income, linked to inflation and providing a pension for their spouse worth two thirds of the full pension after their death, it would mean a pension income of just £21,000 a year. It contrasted this with the rules surrounding defined benefit schemes - which allow people to retire on as much as £50,000 tax efficiently.

The rules have been changed continually over the years. The lifetime cap was only introduced in 2006, at which point it was set at £1.5 million. Any sums over this level were then taxed at 55%. It was designed to increase every year, and did so until 2010, when it reached £1.8 million, and the cuts began. It was cut in 2012 and 2014, and then in April this year, the government reduced it yet again to £1 million.

At the same time, the amount that can be earned from an annuity has been dropping dramatically. In the past nine years, annuity payments have fallen in real terms by two thirds.

Former pensions minister Steve Webb, who is now director of policy at insurer Royal London, said the situation was a 'scandal', and warned the if the government is tempted to tinker even further with the rules, it will make the situation even tougher for savers. He added: "Saving for a pension should be a long-term business, and constant tinkering with tax limits in pursuit of short-term revenue by the Government gains creates uncertainty for savers and makes saving in a pension a less attractive option."

Tom McPhail, head of retirement policy at Hargreaves Lansdown, has been urging the government to scrap the lifetime allowance, as part of a broader simplification of the existing system. He says: "Investors want a simple savings system which helps and rewards those who want to do the right thing. There are generous incentives available from the government but the rules are riddled with complexity and inconsistencies. Our proposals would mean a fairer system with more efficiently targeted incentives, which would help to engage younger workers with retirement saving."

Should you be worried?

At the moment, most savers don't have to worry about the lifetime cap, and there's nothing they need to do beyond saving as much as they can afford for retirement. The vast majority of people will not get anywhere near the £1 million limit at the moment.

For those who do reach the limit, if they stop there, and choose not to link to inflation or leave a pension for their spouse, they can get an annual pension of £45,400, which is the kind of pension income most people can only dream of.

The problems will come if the lifetime allowance is cut further, or if it doesn't increase with inflation over the years, which the government has shown an appetite for. If this happens, more and more people will find themselves crushed by the allowance, and unable to save enough to secure a decent pension for themselves and their other half.

The experts are urging the government to avoid this potential disaster, but given the saving the Treasury can make by slashing tax incentives for pensions, they may find it too tempting to resist.

It means that if you have a large pension pot, or you think you will have by the time you come to retire, it's worth taking precautions, and contacting an advisor sooner rather than later. There is something known as 'transitional protection', which is introduced each time the lifetime allowance changes - which allows people to protect them sums they have built up from tax further down the line. The rules have become increasingly complex, so it's worth involving a professional but you can take steps to avoid breaching the cap and paying tax at 55%.

Dream retirement destinations
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Dream retirement destinations

A study by MGM Advantage discovered that Portugal is the 10th most popular dream retirement destination among Brits.

You get the attractions of the sun, a more relaxed way of life, lower living costs and cheaper property. You can also benefit from pension arrangements that mean your pension rises with inflation.

And if you choose to, you can spend your time with the enormous expat population, feeling like you never left.

In the tradition of the Best Exotic Marigold Hotel, there’s a large number of people keen to move to India, partly in order to enjoy a much higher standard of living than they would be able to afford in the UK.

If course it’s important to consider that your state pension will not rise in line with inflation - so will halve in real terms during your retirement.

This part of Europe offers a great combination of some of the lowest living and housing costs on the continent, along with a more forgiving climate than the UK.

For that reason Bosnia and Herzegovina, Bulgaria, Croatia, Romania, Greece and Turkey are a big draw for retirees.

However, state pension provision varies across the region, so you will need to check whether retiring to these locations will mean your pension continues to rise in line with increases in the UK, or will be frozen when you move overseas.

Italy is a country of contrasts, so anyone planing a retirement there needs to think carefully about whether they want to call a bustling city home, or whether they would be happiest in the mountains or by the sea.

Housing tends to cost less than in the UK, and in some regions it's incredibly cheap. Living costs are also lower than in Britain, and your pension will rise in line with increases in the UK.

Canada is a big draw for British expats of all ages. This spectacular country is known for being welcoming to people from all over the world, and in many cases has no language barrier for Brits. The quality of life is high, and the cost of housing lower than in the UK.

However, you will need to factor in the fact that your UK state pension will be frozen on the day you leave, and you will need some health insurance if you want to replicate the sorts of things that are available for free on the NHS.

As with India, the Far East offers an exciting and dramatic change from life in the UK, with much lower costs, which can buy you a higher standard of living (although bear in mind your state pension will be frozen).

You will need to consider the cultural and practical differences associated with the move, but you will have the opportunity to live in one of the most exciting places in the world.

The weather, lifestyle, space, and lower cost of living means that British expats of all ages are keen to move to Australia.

Property can be a bit of a stumbling block in some areas, as prices have gone up so much. The currency is also strong, which has posed some issues for those who receive their income in pounds, and there’s the fact that the UK state pension will be frozen if you move. However, if you can overcome these things, then a new life in the sun awaits.

The US offers much more affordable housing, and in many respects a lower cost of living than in the UK.

It appeals to those who don’t want to live with a language barrier, but want more space, possibly more sun, and an American Dream of their own.

There are some important things to factor in before you move, such as the additional cost of healthcare, and the exchange rate. However, one bonus is that your state pension will rise at the same rate it does in the UK.

France is close to home, and yet offers cheaper accommodation than the UK, a lower cost of living, and in many regions there’s better weather too.

Your pension will rise at the same rate it would in the UK, and at any time friends and family are just a short boat or plane ride away. It’s no wonder France is the second most popular dream destination for retirees.

It will come as little surprise that Spain tops the list - largely because it’s already the most common overseas retirement destination for Brits.

Millions of us have experienced the delights of the sun, sea, and the lower cost of living while we were on holiday in the country, so it’s hardly a shock that so many want to experience it on a full-time basis in retirement.

Huge falls in the price of property has made this a cheap place to buy, and the fact that your state pension will keep pace with rises in the UK means you’ll be able to maintain your standard of living throughout your retirement.

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