Why you may need a £1 million pension to retire comfortably

Inflation has probably gained more column inches in the past two years than it did in the previous 20.

Price rises soared to a 40-year high during 2022 and remained stubborn for most of last year, eating into the “real value” of your income, savings and investments.

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If you previously weren’t aware of the threat posed by inflation, you almost certainly are now.

This turn of events was indeed unusual but has issued a stark reminder that rising costs must be factored in whenever you set financial goals - especially if what you’re saving and investing for is years away, notably your retirement.

Double-digit inflation aside, even moderate price rises can make a dent in your finances, particularly over long periods.

Failing to consider the increasing cost of living between now and when you plan to stop work could leave you with a glaring shortfall when you reach old age, potentially throwing a spanner in the works of your later-life plans.

How inflation doubles down over 40 years

To examine the impact of inflation over the typical retirement savings time span, we decided to crunch some numbers.

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We based our calculations on the Pension and Lifetime Savings Association’s (PLSA) recently updated retirement living standards, which gives suggested pension pot sizes to achieve a minimum, moderate and comfortable lifestyle in old age. But crucially, these figures don’t take future inflation or housing costs into account.

We calculated the size of pension pot younger pension savers might need in 40 years’ time assuming 2% inflation, the Bank of England’s target.

The table below shows what we found.

The PLSA determined that a single person retiring today needs a pot of at least £490,000 to live comfortably. When factoring in future inflation, those in their 20s could require almost £1.1 million to fund the equivalent lifestyle once they stop working.

These calculations shine a very bright light on how inflation impacts our finances over time. Rest assured, the aim here is to manage your expectations rather than shock you.

Put simply, if prices rise steadily by 2% a year, everything will cost at least twice as much in 40 years’ time. So, rather than paying £1 for a can of Coke, you’ll be paying a bit more than £2. As such you’ll need double the income required today to achieve the same standard of living.

But calculating and forecasting required pension savings is only one part of the jigsaw. It’s equally important to determine what percentage of your earnings you need to commit to get there.

The table shows the pension gap for those aiming for a moderate lifestyle in retirement, based on the median UK salary of £35,000 and various annual pension payment amounts.

We calculated that someone on the average UK wage would need to contribute around 12% of earnings to achieve a moderate retirement, accruing a pot size of around £691,000 in 40 years. We assumed 5% investment growth after charges and 2% annual salary/contribution growth.

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However, if someone on £35,000 keeps to the minimum 8% contribution level (employee pays 5% while employer pays 3%) under auto-enrolment rules, they could achieve a pot size of around £460,000 in four decades’ time. This could leave them with a shortfall of £600,000 or £267,000 to achieve a comfortable or moderate retirement, respectively.

Just a quick word on the assumptions. While the figures assume wages rise 2% annually, not everyone will be fortunate enough to get an inflationary pay hike every year.

In addition, inflation could average more or less than 2% over the next four decades, which could either reduce or increase the level of savings required.

So, what does this all mean?

With increasing living costs and a rising state pension age (which is currently 66 but hiking to 67 and 68 by 2028 and 2046, respectively), building private pension wealth has never been more important.

If you’re planning to retire before the state pension age, you may need to save more because you’ll have a gap to bridge before the payments kick in.

Worryingly, as these figures don’t take housing costs into account, those renting or who retire before clearing their mortgage could need even more. We know that many more people are now renting in their 40s and 50s and many are likely to continue renting into old age, making retirement a lot more expensive.

How can you save enough for a comfortable retirement?

Clearly a comfortable retirement will mean different things to different people. How you want to spend your time is unique to you, meaning you might need to save more or less than figures shown in the table above.

Regardless, the research illustrates the importance of engaging with your current retirement savings as soon as you can.

A good place to start is to round up any existing pensions you have, find out the current values, and work out what that could provide for you in retirement.

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When it comes to saving for later life, starting the process early will give you the best chance of accruing a handsome sum. That’s because you have more years to squirrel money away, and more time to benefit from compound returns.

If you have a workplace pension, find out the maximum your employer is prepared to contribute. You might have to match what they pay, but this is essentially free money, and will relieve you from some of the heavy lifting.

And remember you get tax relief on what you pay in at your marginal rate. So, if your employer offers to pay 8% of your salary if you do too – bringing the total to 16% - you’ll actually pay 6.4% if you’re a 20% taxpayer. If you pay 40% tax, the percentage cost to you drops to 4.8%.

If your employer offers salary sacrifice, where you trade part of your wage for a pension payment, strongly consider it as you’ll save on national insurance (NI) too.

You should also think about increasing contributions every year to keep up with inflation, and whenever you get a pay rise. Even small increases could have a big impact on your long-term pension wealth - and can counter the silent threat posed by price rises - potentially giving you more financial freedom in retirement.

Another important task is to check and understand where your current savings are invested. If you’re in your 20s, 30s and even 40s, you have plenty of time to ride out the ups and downs of the stock market, so don’t be afraid to take some risk with your money.

Being overly cautious with your pension savings early on in life can be harmful as it can stymie how quickly your money grows.

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And finally, make sure you pay sufficient NI contributions to get the full state pension. You need 35 qualifying years to get the maximum amount, which will rise to £11,502 a year from April.

The state pension alone may not be enough to survive on in old age, but it can provide a solid foundation to meet essential retirement outgoings.

If you’re in the early stages of your career, getting a state pension forecast probably isn’t something to worry about yet. But it’s wise to keep an eye on your record over time, especially if you take lengthy career breaks to either raise children or care for elderly relatives.