Pensions – a valuable, tax-efficient way to save for retirement

What is a pension?

For many of us, our pensions are made up of small pots of money, scattered around with our past employers. We receive annual statements from all of them, which are left in a drawer and forgotten about. A lot of younger people are more focused on saving for their first house or topping up an ISA than contributing to their retirement. And over half of 22 to 29-year-olds have no savings at all.

The importance of pensions

Pensions are a very valuable tax-efficient way to save for retirement, according to Nicola Watts, director of Jane Smith Financial Planning.

“Pensions tend to have a bit of a bad name attached to them and people think, why would I contribute to my pension rather an ISA?” she says. “But people should understand that there is usually no difference in the underlying investment [of a pension or a stocks and shares ISA] – it’s the tax treatment that is beneficial in a pension.”

Benefits of having a pension

You can put up to £40,000 a year into a pension without paying tax. This compares to the annual £20,000 limit for a cash or stocks and shares ISA.

There are multiple, massive benefits to saving into a pension. One is the level of protection you are offered. If you are building up a pension pot that is managed by a life insurance provider, or you’ve reached retirement age and are drawing a set income from that contract, like an annuity, and the provider goes bust, you are covered 100% by the Financial Services Compensation Scheme. In comparison, Financial Services Compensation Scheme will cover a maximum of £85,000 of savings in a bank, or £50,000 for investments.

But with rising house prices and less disposable income, it’s no wonder younger people are sometimes seen as apathetic when it comes to saving towards their pensions. The current statutory retirement age is 63 for women and 65 for men, but both will rise to 66 by October 2020 and are projected to rise to 67 by 2028. For many of us, this can feel like a long way off. (For private or company pensions you don’t have to wait that long. Nicola points out you can take out a quarter of the pot, tax-free, at age 55, and you can use the rest as income from that point, paying income tax just like if you were receiving income from a job. In this scenario it is best to seek financial advice first.)

Auto enrolment pension scheme

To kickstart a saving culture, the government introduced auto enrolment in 2012, to encourage employees to contribute to their pensions along with their monthly payroll.

At the moment, at least 3% of an employee’s qualifying earnings is paid into a pension by the employer. Earlier this year the employee contribution went up from 2.4% to 4% and the accompanying tax relief increased from 0.6% to 1%.

Your pension is invested into funds of stocks and bonds and some other asset classes, in line with your time horizon and attitude to risk, and how well your pension performs is down to the investments themselves. The longer that money is invested, the more likely you are to make a good return.

Employees are opted into auto enrolment – hence the name – so you have to proactively opt out if you don’t want to contribute.

If you are tempted to opt out or to contribute less towards your pension, consider the words of Rebecca Aldridge, founder of Neon Financial Planning: “If your employer also pays into your pension, that’s free money – and it’s your money.”

Not all employees have to use their workplace pension, of course.

“We routinely move clients out of company pensions so they can have access to more funds and cheaper fees,” says Rebecca.

Combining pension pots

It is understandable that people get frustrated with multiple small pension pots as they move from one job to the next. We are likely to have many jobs in our lives: a 2018 study found that 43% of millennials planned on leaving their job within the next two years, and only 28% plan on staying in their job for five years. Rebecca says it makes sense to combine your pensions into one pot, if possible, as long as they are less than 10 years old. If they are more than 10 years old, it may mean that there are significant benefits in keeping them where they are.

“Just for peace of mind, it’s simpler and nicer to have one pot of money to look at,” she says. “Sometimes it’s financially sensible to bring them together, but it’s mainly a psychological benefit.”

If nothing else, having them all in one place saves you contacting multiple pension providers to let them know every time you move home or get a new phone number.

How do pensions work for self employed?

When it comes to the self-employed, there is no employer contributing to your pension, and you are not automatically enrolled into a scheme. You will have to choose and pay for a pension product yourself. The most common options are a personal pension or a self-invested personal pension. Both products charge an annual fee and can be found on most investment platforms.

Rebecca says that in her experience, freelancers are “renowned”, however, for having no pension at all, and she does not recommend that. A full state pension is currently just £168.60 a week – if you have paid national insurance contributions for around 35 years. It’s not much to survive on.

“I understand that freelancers’ cashflow can be lumpy, so normally I suggest paying a low monthly amount into a pension, a token amount, really,” she says, “then you can catch up at the end of the year, when you know how much you’ve earned and how much tax you owe.”

At the end of the tax year, business owners and sole traders can allocate a part or even all of their profits to their pension, and offset that amount against their taxes. (All of your profits or £40,000 – whatever figure is lower.) But how much should you contribute?

“It depends what your objectives are,” says Nicola. “If you’re buying a house in the next few years, for example, you might redirect that money to a Lifetime ISA or Help to Buy ISA instead.”

Pension fund management fees

Whether you’re employed or freelance, watch out for costs. Although we mentioned free money from your employer and tax efficiency, a pension is not a free product. There are multiple fees, including an annual fee for the investment platform that the pension sits on, as well as an annual charge for the fund itself. Some providers have extra charges, for example £20 a quarter for administration.

“Costs are the number one thing that will drain your pension,” says Rebecca. “Other than that, pension products are pretty similar – they’re like a can of beans, some will be tastier than others. But it’s still a can of beans. Having said that, a pension can do you enormous favours. Think of it as the superhero for your future.”

Understanding pensions

If you have further questions about your pension, there are some good places to learn up. The Money Advice Service has a detailed section on pensions and retirement. The government website also can answer some of the more basic questions about your state pension. More general information, including on how to pick your own personal pension, can be found at the Citizens Advice website. If you’re employed and part of a workplace scheme, speak to your line manager or your HR department, which can do helpful things on your behalf such as update your details when you move house.

Of course, anyone can benefit from independent financial advice from an IFA. This is very important, especially if you want to transfer all your pension pots into one place, to make sure you avoid paying extra fees or losing certain financial benefits.

Important: With investments, your capital is at risk. Pensions can go down in value as well as up, so you could get back less than you invest.